What is a Roth 401(k)?
Unlike a Traditional 401(k), a Roth 401(k) has you putting the money in after you pay taxes. That means at retirement, you’ll enjoy tax-free distributions.
Published January 13th, 2021
Table of Contents
- A Roth 401(k) combines the features of a Traditional 401(k) with the tax setup offered by a Roth IRA.
- With a Roth 401(k), you pay taxes on the funds before they’re put into the account.
- Roth 401(k) participants receive tax-free distributions when they take the money out at retirement.
Traditional 401(k) accounts have their benefits--namely that they let you put money in before you’ve paid taxes on it. But there’s a price with that tax-free contribution. You pay taxes when you take the money out, which will likely be after you’ve left the workforce to enjoy retirement. Enter the Roth 401(k). Like a Traditional 401(k), you put money in to fund your retirement. But unlike a Traditional 401(k), a Roth 401(k) has you putting the money in after you pay taxes. That means at retirement, you’ll enjoy tax-free distributions.
What Is a Roth 401(k)?
When you’re looking at what is Roth 401(k), it can help to take a look at the basic setup of both types of Roth retirement accounts: the Roth IRA and the Roth 401(k). Roth products were named after William Roth, the Delaware senator who sponsored the legislation creating it. “Roth” is most often associated with the Roth IRA, which was introduced as an alternative to Traditional 401(k) accounts, which is a popular job perk available to today’s employees.
The Roth 401(k) works similarly to the Roth IRA in many ways. But unlike the Roth IRA, with a Roth 401(k), you’ll have to start taking distributions from your retirement fund at by the age of 72 to avoid penalties if you’re not still working.
Example of a Roth 401(k)
The defining factor of any Roth definition is that the money is put in after taxes are taken out. Usually, this means that your employer takes the funds from your paycheck after taxes have been withdrawn. You simply sign up and let everything happen on its own.
But also tied into the Roth meaning is the concept of a designated Roth 401(k). With this type of account, an employer can match contributions, but the “Roth” treatment goes away at that point. The employer-contributed money is kept in a separate account and given the same tax treatment a Traditional 401(k) would receive.
Here’s a simple example of how a Roth contribution works. Your paycheck is $1,000 and you’ve designated 5 percent to go toward your Roth 401(k). Your employer would calculate your taxes, then take 5% of the sum remaining to put into your Roth 401(k). When you retire and take your distributions, you won’t be responsible for paying any taxes on it since you paid taxes on that money when your employer originally put it into the account.
If you take that same example and apply it to a Traditional 401(k), your employer would first calculate 5% of your earnings, then move it to your 401(k). Taxes would be taken on the amount remaining after that 401(k) contribution had been deducted so that you’d only pay taxes on your income. However, when you take the money out at retirement, you’d be responsible for paying income taxes on it.
Roth 401(k) vs. Traditional 401(k)
What is Roth contribution compared to a Traditional 401(k)? First, it can help to look at the similarities. Both are subject to the current contribution limits. For the 2021 tax year, you can contribute up to $19,500 to your 401(k). This applies whether it’s of the Traditional or Roth variety. Whether you put your funds in pre-tax or Roth 401(k) is the biggest difference between a Roth 401(k) and a Traditional 401(k). There are benefits to either approach. With a Traditional 401(k), you’ll be able to move some of your income into a retirement savings account, where it can start earning interest. With a Roth 401(k), though, you pay taxes now so that when you retire, and your income drops, you won’t have to worry about paying them.
Who Benefits Most from Roth 401(k)s?
In addition to determining what does Roth mean, it’s important to look at whether it’s the right choice for you. For some people, a Traditional 401(k) makes more sense.
Since your 401(k) Roth contribution is taxed now, it’s usually the best option for those in lower tax brackets. If you’re a high earner paying taxes at the 35 percent tax bracket, chances are you’ll see a big drop in income when you retire. That could have you paying lower taxes on that money than you would now, at 35 percent. For that reason, a Traditional 401(k) might make more sense for you, allowing you to pay taxes then versus now.
For lower earners, a Roth 401(k) means you’ll pay taxes now, when you’re at a low tax bracket. As tax brackets increase between now and your retirement date, having the tax already taken care of will give you a big relief if, say, the lowest tier gets hit with a 20 or 30 percent income tax.
Plan for a better future
Are you having trouble deciding whether a Traditional 401(k) or Roth 401(k) savings strategy makes sense for you?Talk through your situation with a CFP® Professional →
History of the Roth 401(k)
The Roth 401(k) debuted as part of the Economic Growth and Tax Relief Reconciliation Act of 2001. It was created to give employees the option of investing after-tax dollars to their employer-provided investment accounts. In 2006, employers were first able to offer Roth 401(k)s to their employees.
Whether you choose a Traditional 401(k) or Roth 401(k), a 401(k) investment account can give you the funds you’ll need after retirement. If you’ve signed up for a 401(k) through your employer, it’s important to make sure you’re investing enough to cover your post-retirement cost of living. A Certified Financial Planner® can take a look at your retirement savings and issue guidance on ways you can reduce your taxability while also saving for the future.
Cashing Out your 401(k)
Understanding Roth 401(k)s
Roth IRA Basics