Advantages of a Roth 401k

What is a Roth 401k? Find out here and decide if you need one.

An employer-sponsored Roth 401k option can be a wise investment strategy for saving for retirement. Roth 401k investment accounts offer many advantages to employees that are unavailable with traditional 401ks or Roth IRAs, giving you not only more flexibility and options in your retirement planning but also the ability to maximize your retirement income.

So what is a Roth 401k? A Roth 401k is a type of retirement account that employers offer; it allows you to make contributions with after-tax dollars. The money you contribute, including earnings, can be withdrawn tax-free in retirement. Here are the benefits of saving for retirement with a Roth 401k.

6 Advantages of a Roth 401k

A Roth 401k, Roth IRA and traditional 401k can each have a place in your retirement planning — they all offer tax advantages not available with a savings account. But there are key differences among the three types of retirement accounts. Take a look at some of the benefits of contributing to a Roth 401k versus a traditional 401k or Roth IRA:

1. Tax Diversification

You make contributions to your Roth 401k and Roth IRA with post-tax money. You can grow your earnings tax-free. When it comes time for you to withdraw funds at retirement, you can do so without being taxed. On the other hand, with a traditional 401k, you contribute with pre-tax income, and your withdrawals are taxed.

Learn: 401k vs. Roth 401k — Which Is Better for Your Retirement Plan?

2. Tax-Free Earnings

Because you’re contributing after-tax income, you get the benefit of tax-free earnings in both a Roth 401k and Roth IRA. You won’t pay any upfront tax benefits, but if you meet certain conditions, your Roth 401k and Roth IRA contributions and all accumulated earnings on those contributions grow free from federal income tax.

The conditions for the Roth 401k relate to whether the distribution meets the definition of a “qualified distribution.” If your distribution isn’t qualified — for example, if you receive a payout before the five-year waiting period has elapsed — the portion of your distribution that represents an investment on those earnings will be taxable and will also be subject to a 10 percent early distribution penalty if you’re under the age of 59.5.

3. Tax-Free Withdrawals in Retirement

With a Roth 401k, you make contributions to the account with money from your paycheck that has already been taxed. After your money is in the account, not only do your earnings grow tax-free, but once you reach the age of 59.5, you pay no taxes when you start making withdrawals.

4. No Required Distributions

With a traditional 401k, you must begin withdrawing some of your money at age 70.5, which is referred to as the required minimum distribution. Even if you don’t want to, you’re still required to take a distribution and pay tax on it each year. However, with a Roth 401k, you can avoid the RMD at age 70.5 by rolling the account over to a Roth IRA, which doesn’t have the RMD.

5. Lower Tax Rate If You’re in a Lower Tax Bracket

A Roth 401k is a better option than regular 401ks for young individuals in lower tax brackets who expect their tax bracket to increase when they’re in retirement. When you have a Roth 401k, not only are you getting your tax obligation paid when you’re at a low tax rate, but later on in life, you can retire tax-free.

See: IRS Federal Tax Brackets — Frequently Asked Questions

6. High Contribution Limit

The annual employee Roth 401k contribution limit for 2017 is $18,000, according to the Internal Revenue Service. You’re allowed to contribute an extra catch-up amount of $6,000 if you’re 50 years old or older. The limit is the same for a traditional 401k too, but with a Roth 401k, your invested dollars are more valuable because they’re not taxed when you take a distribution, unlike traditional 401ks.

If you’re fortunate enough to have both an employer-sponsored 401k and Roth 401k plan available, the good news is that you don’t have to invest in one or the other. Typically, you can choose to invest in both a traditional and Roth 401k as long as your total contributions — including contributions in a non-employer sponsored Roth IRA — don’t exceed the IRS limit.

Find Out: 10 Big 401k Questions to Ask Your Employer

Different retirement investment accounts each offer benefits and disadvantages; carefully consider your personal financial situation and work with your advisor or plan specialist before committing to one account type. As for using a Roth IRA versus Roth 401k or both, it’s usually prudent to first contribute to the Roth 401k to take advantage of all employer matching before contributing to the Roth IRA.