HR Glossary  /  Roth 401(k)
Roth 401(k)8 min read
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What is a Roth 401(k)?

When it comes to planning for retirement, there’s no one-size-fits-all approach—especially with the different savings options available. Among them, the Roth 401(k) often raises eyebrows for those less familiar with how it works. It’s an option that combines the financial flexibility of a traditional 401(k) with the tax advantages of a Roth IRA. This way, it offers a unique way to grow your savings tax-free. But what exactly sets it apart, and why should you care?

Understanding the ins and outs of a Roth 401(k) can help you make more informed decisions about how to manage your money now so you can live comfortably in the future. Let’s take a look into what makes a Roth 401(k) work and why it might just be the key to a more flexible, tax-savvy retirement.

A Roth 401(k) is an employer-sponsored retirement savings account that combines the features of a traditional 401(k) and a Roth IRA. The primary distinction is how contributions are taxed. With a Roth 401(k), contributions are made with after-tax dollars, so taxes are paid when the money is deposited into the account. However, withdrawals made during retirement—provided that the account has been held for at least five years and the account holder is at least 59½—are tax-free. This plan allows employees to enjoy tax-free growth on their investments and frees them from the concern of future tax rates affecting their retirement income.

A Roth 401(k) offers a type of tax break, but it's different from the tax break you get with a traditional 401(k). In essence, a Roth 401(k) merges the pre-tax benefits of a traditional 401(k) with the tax-free withdrawal perks of a Roth IRA. A pretty good deal, right?

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The main difference between a Roth 401(k) and a traditional 401(k) lies in how the two accounts are taxed. Contributions to a traditional 401(k) are made with pre-tax dollars, which reduces your taxable income for the year. However, taxes are owed when you start making withdrawals in retirement. In contrast, a Roth 401(k) requires you to pay taxes upfront on your contributions, but withdrawals—including earnings—are tax-free in retirement.

Choosing between the two largely depends on your current tax situation and future expectations. If you believe you’ll be in a higher tax bracket in retirement, a Roth 401(k) might be the better option, as you’ll lock in today's tax rate. On the other hand, if you anticipate being in a lower tax bracket during retirement, a traditional 401(k) could offer more immediate tax advantages.

When it comes to planning for retirement, understanding the unique benefits of a Roth 401(k) can help you make a more informed decision. This section highlights why the Roth 401(k) might be a worthwhile investment option for your longer-term financial security.

Tax-free Withdrawals in Retirement

One of the best parts of a Roth 401(k) is the ability to withdraw money tax-free when you retire. As long as your account has been open for at least five years, and you’re 59½ or older, you won’t pay tax on either the contributions or the earnings.

Let’s say you’ve been diligently saving and now have $500,000 in your Roth 401(k). By the time you retire at 60, all that money, including the earnings, is yours to use without paying a dime in taxes—as long as you’ve held the account for at least five years and meet the age requirement. Compare this to a traditional 401(k), where you’d owe taxes on every dollar you withdraw.

Flexibility for High-Income Earners

If you’re a high earner, the Roth 401(k) could be a game-changer for you. While the Roth IRA has income limits, the Roth 401(k) does not. You can contribute to a Roth 401(k) regardless of your salary.

Suppose you're earning a six-figure salary and want to put away as much as possible for retirement. With a Roth IRA, you might not even qualify to contribute, but with a Roth 401(k), you can contribute up to $23,000 in 2024, regardless of how much you make. This gives high earners a powerful tool for building tax-free income in retirement.

Employer Matching Contributions

Many employers offer to match contributions to Roth 401(k) plans. However, there’s a twist: while your contributions go into the Roth account, employer contributions are treated like those for a traditional 401 k. This means that while your own contributions grow tax-free, you’ll owe taxes on the employer match when you withdraw it in retirement. In any case, employer matching can significantly raise your retirement savings, so it's a benefit worth maximizing.

Let’s say your employer offers to match 4% of your salary, and you earn $100,000 a year. If you contribute 4%, or $4,000, to your Roth 401(k), your employer will contribute an additional $4,000. You’ll only owe taxes on that portion when you withdraw it in retirement.

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Contributing to a Roth 401(k) can be a bit different from other retirement accounts. But once you understand how it works, you’ll see that it’s not complicated—and there are smart ways to get the most out of it.

Employer-Sponsored Plans

First things first: a Roth 401(k) is typically offered through your employer. To contribute to a Roth 401(k), your employer must usually offer the plan as part of its benefits package. Unlike a Roth IRA, which you can open on your own, a Roth 401(k) is tied to your employer's retirement offerings.

Contribution Limits and Rules (Based on IRS Guidelines)

Like traditional 401(k) plans, the Internal Revenue Service (IRS) sets annual limits on how much you can contribute to a Roth 401(k). In 2024, the contribution limit is $23,000 if you’re under 50, and if you’re 50 or older, you can make an additional catch-up contribution of $7,500. For example, if you’re 55 and want to maximize your savings, you could contribute a total of $30,500. Keep in mind that these limits are combined across all your 401(k) accounts, so if you have both a traditional and Roth 401(k), your total contributions can’t exceed the limit.

Strategies for Maximizing Contributions

To make the most of your Roth 401(k), it’s smart to contribute as much as you can, especially if you expect to be in a higher tax bracket in the future. For instance, if you’re in your 30s and early in your career, paying taxes on your contributions now at a lower rate can save you money down the road when you might be in a higher tax bracket during retirement.

Another strategy is to check that you’re contributing enough to take full advantage of any employer match. Even though employer contributions are treated as traditional 401(k) funds (meaning they’ll be taxed when withdrawn), it’s still free money that helps your retirement savings grow faster. For example, if your employer matches 4% of your salary, and you’re earning $70,000, contributing at least $2,800 to your Roth 401(k) will guarantee you get the full employer match.

When comparing a Roth 401(k) to a Roth IRA, the main differences lie in contribution limits, income restrictions, and distribution rules. A Roth 401(k) has higher contribution limits and no income cap, which allows high earners to participate. Meanwhile, a Roth IRA has lower limits and imposes income thresholds, which restricts eligibility for those earning over a certain amount.

Another key difference is in Required Minimum Distributions (RMDs). Roth 401(k) accounts are subject to RMDs starting at age 75, while Roth IRAs have no RMDs. This offers more flexibility in retirement planning.

Pros and Cons of Having Both a Roth 401(k) and a Roth IRA

Having both a Roth 401(k) and a Roth IRA can provide a more flexible and well-rounded retirement strategy. One major advantage is that you can contribute to both, potentially saving over $30,000 per year depending on your age, which significantly increases your retirement savings. Even if your gross income exceeds the Roth IRA limit, you can still contribute to a Roth 401(k), and employer matching further raises your savings without added cost.

However, managing two accounts means dealing with different rules, like varying contribution limits and withdrawal policies. Another downside is that employer contributions to a Roth 401(k) are pre-tax, which could result in taxes when you withdraw that portion in retirement. While a Roth IRA offers more investment flexibility, its income limits may restrict access for higher earners.

Employer Considerations for Offering Roth 401(k)

When thinking about adding a Roth 401(k) to your benefits package, you should be aware of the benefits it can bring to your employees, as well as the compliance and education aspects. As we’ve been saying, having a Roth 401(k) available alongside traditional 401(k) plans can really help with retirement savings options. Employees get the chance to contribute after-tax dollars, which means they can enjoy tax-free withdrawals in retirement.

But don’t forget about compliance with IRS rules. As we’ve already mentioned, in 2024, the contribution limits are set at $23,000 for those under 50. For employees aged 50 and older, there’s an opportunity to make an additional catch-up contribution of $7,500, which allows a total contribution of $30,500 for those who qualify. However, note that these limits are combined across all 401(k) accounts. So if an employee has both a traditional and a Roth 401(k), their total contributions cannot exceed these limits.

Educating your team about the benefits of a Roth 401(k) is essential too. Some employees might not fully understand the differences between Roth and traditional accounts, or how a Roth 401(k) can offer long-term tax advantages. Hosting informational sessions or providing easy-to-digest resources can really help them see how contributing to a Roth 401(k) fits into their overall financial picture.

Are employer matching contributions included in a Roth 401(k)?

Yes, employer matching contributions can be part of a Roth 401(k). However, keep in mind that these contributions are made with pre-tax dollars, which means they will be taxed when withdrawn in retirement, unlike your Roth contributions, which are tax-free.

Can employers offer both a traditional 401(k) and a Roth 401(k) in the same plan?

Absolutely! Many employers choose to offer both options within the same retirement plan. This allows employees to decide which type best fits their financial situation and retirement goals. Just remember that the contribution limits apply across both accounts.

How are employer matches in a Roth 401(k) treated for tax purposes?

Employer matches in a Roth 401(k) are considered pre-tax contributions, meaning they'll be taxed when withdrawn in retirement. So, while your contributions grow tax-free, the employer’s contributions will be subject to taxes down the line.

What happens if an employee changes jobs or retires?

When an employee changes jobs or retires, they have a few options for their Roth 401(k). They can leave the funds in the current plan, roll them over into a new employer’s plan (if allowed), or convert the account into a Roth IRA. Each option has its benefits and potential tax implications, so it’s good to think through the choices carefully.

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