Employers that offer a 401(k) plan to help you save for retirement might also offer a Roth 401(k). A Roth 401(k) has some advantages of a traditional 401(k) and a Roth IRA, and it differs from a traditional 401(k) in much the same way a Roth IRA differs from a traditional IRA. Understanding these differences is the key to deciding if a Roth 401(k) is the best way for you to save for retirement.
To help you understand how this savings account might fit into your retirement planning this guide to the Roth 401(k) will address the following topics:
- What Is a Roth 401(k)?
- Benefits of a Roth 401(k)
- Roth 401(k) Withdrawal Rules
- Roth 401(k) Contribution Limits
- Understanding Taxes With a Roth 401(k)
- Roth 401(k) vs. Roth IRA
- Is a Roth 401(k) Right for You?
A Roth 401(k) is an employer-sponsored retirement account that allows employees to contribute money to save for retirement. When you contribute to a Roth 401(k), you contribute money that you have already paid taxes on. When you withdraw the money in retirement, you pay no taxes on either the contributions or the gains you have earned while the money was invested in the account.
A Roth 401(k) has some of the features of a traditional 401(k), such as high contribution limits and the possibility of an employer match. It also has some features of a Roth IRA, such as the ability to take tax-free distributions in retirement.
Also See: Which Type of 401(k) Is Right for You?
A Roth 401(k) has several benefits when compared with other types of retirement accounts.
- Tax-free distributions: Because you have already paid taxes on the money you contribute to your Roth 401(k), you will not be taxed on your distributions. You will also not be taxed on any gains that your investments return in your Roth 401(k), which is a big advantage over taxable retirement accounts like traditional 401(k)s, especially if you start saving early and have significant gains over the lifetime of your account.
- Employer matching: Like a traditional 401(k), your employer can match all or part of your Roth 401(k) contribution as an incentive for you to save for your retirement. This is free money, so you should always contribute at least enough to get the full employer match. But there’s a caveat: The employer match must be deposited into a traditional 401(k) account — you will be taxed on your distributions from that account. This is because your employer contributes pre-tax money into this account, and they’re not going to pay your taxes for you.
- Higher contribution limits: If you have an IRA — Roth or otherwise — you can only contribute $6,000 in 2019, plus another $1,000 if you’re 50 or older. With a 401(k), you can contribute up to $19,000 plus another $6,000 if you’re 50 or older. These Roth 401(k) limits are the total you can contribute, whether you have a traditional account, a Roth account or both. That nest egg can grow much faster if you use a 401(k) instead of an IRA.
- No income limits: Anyone can contribute to a Roth 401(k) if their employer offers one, no matter how much they earn.
Read More: 401(k) vs. Roth 401(k)
The withdrawal rules for Roth 401(k)s are a little bit of a hybrid of traditional 401(k) and IRA rules. You must begin taking withdrawals at age 70 1/2 unless you are still working and do not own 5% or more of your company. You can take withdrawals with no penalty when you reach age 59 1/2 or are disabled. If you die, your heirs will not pay a penalty when they take distributions.
Compare: How To Make A 401(k) Withdrawal
In 2019, you can contribute a total of $19,000 to all 401(k) accounts, plus an additional $6,000 catch-up contribution if you are over age 50. If you have other accounts, whether they’re traditional or Roth 401(k)s, this is the total maximum amount you can contribute to all of your accounts combined. Employer contributions don’t count toward this limit.
Withdrawals from a Roth 401(k) are not taxed if they’re considered qualified distributions. In order for a distribution to be considered qualified, it must meet these criteria:
- The account must have been held for at least five years.
- You must be at least 59 1/2 years old.
Qualified distributions may also be taken if you’re disabled, or if you die and the account is passed on to your heirs.
Note that your entire qualified distribution is free of taxes. This means that the money you contributed, plus all of the gains you earned on the money while it was invested, can be withdrawn tax-free. This is what makes the Roth 401(k) such a powerful retirement savings tool.
If you don’t have a 401(k) plan at work, you can open a Roth IRA. A Roth IRA has some, but not all, of the benefits of a Roth 401(k). Here’s how these retirement plans stack up:
|At a Glance: Roth 401(k) vs. Roth IRA|
|Roth 401(k)||Roth IRA|
|Contributions||Made with after-tax dollars||Made with after-tax dollars|
|Contribution Limits||$19,000 plus a $6,000 catch-up if over 50 in 2019||$6,000 plus a $1,000 catch-up if over 50 in 2019|
|Employer Contributions||Yes, but must be deposited into a pre-tax account like a traditional 401(k)||No|
|Income Limits||None||In 2019, modified adjusted gross income must be $203,000 or less for a couple, $137,000 or less for a single|
|How Withdrawals Are Taxed||Withdrawals are not taxed as long as the account is held for at least five years and distributions are due to attaining age 59 1/2, death or disability.||Withdrawals are not taxed as long as the account is held for at least five years and distributions are due to attaining age 59 1/2, death or disability. May also take a distribution for a first-time home purchase.|
|Required Minimum Distributions||Distributions must begin in the year you turn 70 1/2 unless you are still working and not a 5% owner of the company.||No required distributions|
A Roth 401(k) can be a powerful retirement savings vehicle, particularly if you start using it early. The ability to invest your contributions and then withdraw both contributions and gains tax-free can make a big difference in the amount of money you’ll have in your pocket when you retire. The downside is that you have to pay the taxes now
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Karen Doyle is a personal finance writer and former financial advisor. She never passes up the employer match.