The employer-sponsored 401k plan comes in two different account types: Traditional and Roth. The main difference between them is when and how they get taxed. Traditional 401k contributions give you tax benefits when you contribute money into your plan. Roth 401k contributions give you tax benefits when you withdraw money from your plan.
Here’s everything you need to know about a Roth 401k, and how it compares to a traditional 401k plan.
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What is a Roth 401k?
Like a Roth IRA, a Roth 401k is simply a “Roth” version of a traditional 401k. Everything else is the same, except for when you get taxed.
Not all companies offer a Roth version of the 401k. But if they do, you get to choose whether you want a tax break today, or in retirement. If you choose to contribute to a Roth 401k, you pay income taxes now, but do not owe any taxes when you take distributions in retirement.
Roth 401k vs traditional 401k
The only two differences between a Roth 401k and traditional 401k are how contributions and withdrawals are taxed. Everything else like contribution limits, deadlines, eligibility, and investment options are the same. The Roth 401k and traditional 401k are eligible for receiving employer match contributions, and can be invested in the same things.
Contribution tax differences
- Traditional 401k: Contributions are made in pre-tax dollars that you haven’t paid taxes on yet.
- Roth 401k: Contributions are made in after-tax dollars that you’ve already paid income taxes on.
With a Roth 401k, your contributions are made with after-tax dollars. You pay income taxes before you contribute into your plan. You don’t get any tax benefits at the time of contribution, but your withdrawals in retirement are tax-free.
In comparison, a traditional 401k is funded with pre-tax dollars. You contribute with money that you haven’t paid taxes on yet. Instead, the contribution amount gets deducted from your income tax. You get an immediate tax break at the time of contribution, but withdrawals in retirement are taxed as regular income.
Withdrawal tax differences
- Traditional 401k: Withdrawals in retirement are taxed as regular income.
- Roth 401k: Withdrawals in retirement are completely tax-free.
Potential gains are a major factor in deciding whether to contribute to a traditional or Roth 401k. Both the traditional 401k and Roth 401k have tax-free compounding. You don’t pay any taxes when you sell assets in your account. However, you still owe taxes on gains with a traditional 401k. Every withdrawal is taxed as regular income.
For example, if you contributed $50,000 to a 401k and your account grows to $500,000…
- With a Roth 401k, you don’t pay any taxes on the entire $500,000. You can withdraw the entire amount tax-free.
- With a traditional 401k, you’ll be taxed on withdrawals of the $500,000 in your account.
Also read: 401k Withdrawal Rules & Penalties Explained
Withdrawal 5 year rule
For both the traditional 401k and Roth 401k, you must be at least 59½ years of age in order to take qualified distributions without any penalties.
However, the Roth 401k also has one additional requirement: The Roth 401k account must be at least 5 years old. The 5 year date starts January 1, the year you make your first contribution.
Roth 401k contribution limits
The Roth 401k contribution limits are the same as a traditional 401k.
For 2022, the Roth 401k contribution limit is $20,500. If you’re at least 50 years old, you get an additional $6,500 in catch up contributions, bringing your total contribution limit to $27,000.
For 2023, the Roth 401k contribution limit is $22,500. If you’re at least 50 years old, you get an additional $7,500 in catch up contributions, bringing your total contribution limit to $30,000.
If your company offers a Roth 401k, you can choose which account you want to contribute you to each year, and can even contribute to both accounts in the same year. However, your total contributions must not exceed the yearly contribution limit.
Is a Roth 401k tax deductible?
Roth 401k contributions are not tax deductible. You contribute to a Roth 401k with income that you’ve already paid income taxes on. Only traditional 401k contributions are tax deductible.
Benefits of a Roth 401k
The main benefit of a Roth 401k is that your withdrawals in retirement are tax-free.
Roth 401k contributions are eligible for employer matches, if your company offers employer match contributions.
High contribution limits
You can contribute up to $20,500 into a Roth 401k for 2022 and $22,500 for 2023. If you’re 50 years of age or older, you can contribute up to $27,000 for 2022 and $30,000 for 2023. In comparison, a Roth IRA only has a contribution limit of $6,000 ($7,000 if age 50+) for 2022 and $6,500 ($7,500 if age 50+) for 2023.
Can employers contribute to a Roth 401k?
No, employers cannot contribute to a Roth 401k and can only contribute to a traditional 401k. If your employer offers employer matching contributions, you can receive employer matches for your contributions to a Roth 401k. However, your employer’s contributions will always go into a traditional 401k.
Also read: Companies with the Highest 401k Employer Match
When can I withdraw from a Roth 401k?
You can start making withdrawals from your Roth 401k when you reach the age of 59½ and your account is at least 5 years old. Withdrawals made before you turn 59½ years old, or before your account is at least 5 years old, are hit with a 10% penalty plus income taxes.
Read the full guide on Roth 401k withdrawal rules.
Can I withdraw contributions any time like a Roth IRA?
A Roth IRA has a unique rule that lets you withdraw only your contributions from your account at any age without penalties or taxes. Unfortunately, this rule only applies to the Roth IRA. You cannot withdraw contributions from a Roth IRA, without penalties, until you reach the age of 59½.
Does a Roth 401k have RMD?
Yes, a Roth 401k has required minimum distributions (RMD) and you must start taking distributions from your account each year once you turn 72 years old. Failure to take your RMD involves a steep penalty of 50% of the amount you were supposed to withdraw.
Which one’s better? Roth or traditional 401k?
The decision ultimately comes down to when you want to pay taxes. Do you want to get taxes out of the way today or do you want to defer them until retirement?
One good question to ask yourself is: Do you think your tax rate be higher or lower in retirement?
If you’re in a higher tax bracket today, and think your rates be much lower in retirement, pre-tax contributions to a traditional 401k may seem more attractive. If you’re in a lower tax bracket, and believe your tax rates will be much higher in retirement, contributions to a Roth 401k could be the smarter decision.
Of course, your income and tax rates for the future are both relatively unknown and difficult to predict today.
Another thing to consider is that a 401k plan typically only has a few investment options, and you can typically only invest in mutual funds. A Roth account can be especially advantageous when you’re investing in assets that have a higher-than-normal return potential. For example, if you turn $10,000 into a $1M, not having to pay taxes on the $990,000 in gains when you withdraw can be a huge savings on your tax bill. But most 401k plans do not let you invest in alternative assets and you’re limited to just mutual funds.
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