Retirement. 

While it may feel like a long-time coming, it can also seem like an insufficient amount of time to save everything you need. 

So how can you prepare?

A traditional 401k has been the go-to investment option for many years. But in the last two decades, another tax-advantaged vehicle has seen increased interest: a Roth 401k. 

What is a Roth 401k, and how can it help you reach your retirement “number”?

What Is A Roth 401k?

A Roth 401k is an employer-sponsored retirement account you fund using after-tax dollars. The gains grow tax-free and qualified withdrawals remain tax-free. 

Roth and traditional accounts tend to behave oppositely. 

While payroll deferrals to a traditional 401k lower your taxable income, Roth 401k deferrals don’t provide that immediate tax deduction. Instead, the tax benefit comes later, in retirement, with tax-free distributions if you follow the rules. 

Roth 401ks are relatively new on the retirement savings scene, only available for the last 16 years. Since traditional 401ks have been a staple since the late 1970s, people tend to know a lot more about them than Roths. 

But Roth 401ks can be an excellent addition to your retirement strategy.  

Why?

  • Tax-free earnings and distributions. With a Roth 401k, earnings and distributions can be tax-free in your golden years. But a word of caution: like a Roth IRA, penalties may apply if you make withdrawals before you turn 59 1/2 or if the account is less than 5 years old.
  • Significant contribution limits. In 2022, you can make payroll deferrals up to an annual maximum of $20,500 with an extra $6,500 in catch-up contributions if you’re 50 and older. Keep in mind that the annual contribution limit applies to your combined contributions to the traditional and Roth accounts. 
  • Rollover potential. Since you fund Roth 401ks with after-tax money, converting the funds to a Roth IRA is much more streamlined. You can do this after you change jobs or potentially as an in-service rollover while you’re still working, but doing so depends on the plan’s unique rules. A significant benefit of rolling it into a Roth IRA is avoiding RMDs in retirement. 

If you can afford to let some tax deductions go today, it can pay off handsomely later!

How Does A Roth 401k Differ From A Roth IRA?

When you think about “Roth” accounts, your mind likely jumps to a Roth IRA. But there are some significant differences between these two retirement vehicles. 

Let’s take a closer look. 

Roth IRA

  • There are income limits for direct contributions. Check the IRS chart to see if you’re above the thresholds. High earners can still access this account via a Roth conversion, but this strategy has additional tax implications.
  • $6,000 annual contribution limit in 2022 with an extra $1,000 in catch-up contributions if over 50.
  • Roth IRAs don’t have RMDs.
  • You tend to have broader investment options with Roth IRAs

Roth 401k

  • You can contribute more to a Roth 401k—$20,500 with $6,500 in catch-ups in 2022.
  • Roth 401ks don’t have income limits for contributions, meaning high earners have increased access to this account. 
  • Roth 401ks do have RMDs
  • You can only invest in the securities your plan offers, which tend to be more minimal than IRAs. 

Check out the IRS’s Roth comparison chart to better understand your options.

Why Roth 401ks Can Be Useful For Your Retirement Plan

As you’re planning for retirement, one of the most important tools is tax diversity. And diversification, in general, is essential as it helps mitigate ongoing exposure to market risk. 

Building up assets with different tax treatments affords you more flexibility when you need to withdraw the funds. For example, suppose you store all of your money in tax-deferred accounts, like a traditional 401k. In that case, you may end up in a higher tax bracket than you realized in retirement since the IRS will tax all the distributions as ordinary income. 

But adding some taxable (brokerage accounts) and after-tax (Roth, HSA, etc.) savings enables you to be more creative with your withdrawals and strategically manage your tax liability long-term.

In terms of Roth savings, your money could actually be worth more in the future because a) theory of compounding and b) you don’t have to pay taxes when you take it out. 

You can count on every dollar that’s in your Roth 401k. The same isn’t necessarily true for a traditional 401k since it’s subject to income tax. 

Leveraging Roth accounts in retirement can be beneficial in keeping more money supporting your lifestyle and less lining Uncle Sam’s pockets.

The Top Benefits of Investing In A Roth 401k

While there’s no “one-size-fits-all” investment plan, you may benefit from investing in a Roth 401k if you’re:

  • An early-career professional
  • Currently in a lower tax bracket
  • Have most of your investments in traditional accounts   
  • Are looking to increase the diversification of your portfolio
  • Expect to retire in a higher tax bracket than today
  • Anticipate that tax rates themselves will increase in the future

Are you wondering if investing in this account makes sense for you this year? Check out this chart to provide some context.

Should-I-Contribute-To-My-Roth-401k-2022

The Most Common Disadvantages of Investing In Roth 401k’s

For all the benefits that Roth 401ks can bring to the table, they aren’t the best solution for everyone at every time.

A Roth 401k might not be the right move if:

  • Currently, you’re in a high tax bracket and would benefit from pre-tax savings. 
  • You intend on retiring in a lower tax bracket.
  • The plan offers limited investment options, and you want to focus on Roth conversions to build up your Roth IRA.
  • A Roth IRA is a significant part of your estate plan.

You’ll Probably Use Both

If you have access to both traditional and Roth 401k through work, odds are that you’ll end up investing and benefiting from both types of accounts throughout your career. 

Since your situation will likely continually evolve, there may be different moments where one account will serve you better than the other. We can help you create an ongoing plan that ensures you’re making the most of your tax and investment opportunities today and into the future.

Are you wondering if investing in a Roth 401k makes sense for your financial situation? Schedule a call with us today.  

Disclaimer

The contents of this article are for general information and educational purposes and should not be construed as specific investment, financial planning, tax, accounting, or legal advice. Please consult with a professional advisor before taking any action based on the contents of this article. 

All investment and financial planning strategies involve risk of loss that you should be prepared to bear. We cannot guarantee any investment performance whatsoever, and past performance is not indicative of potential future returns.