What is a Roth 401(k)?

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Updated on Wednesday, January 8, 2020

You’ve probably heard of a Roth Individual Retirement Account (IRA) and are at least somewhat familiar with 401(k) plans, but what about a Roth 401(k)? Here’s what you need to know about this increasingly popular hybrid option some employers offer to help their employees save money for retirement.

What is a Roth 401(k)?

Roth 401(k)s get their name from former U.S. Rep. William Roth of Delaware, who’s credited with establishing Roth IRAs as part of the Taxpayer Relief Act of 1997. In 2006, as an extension of that legislation, employers were able to begin offering Roth 401(k)s, which follow the same tax principals as Roth IRAs — you pay taxes on contributions up front so you have access to tax-free funds during retirement.

Roth 401(k)s operate much like traditional 401(k)s. The difference lies in when you pay taxes on the contributed funds. With a traditional 401(k), the money you put away is taken out of your paycheck before you pay taxes on it. Of course, taxes are unavoidable and you’ll have to pay taxes on the withdrawals you make later in life when you’re retired.

On the other hand, if you contribute to a Roth 401(k), you pay taxes on the funds during the same year in which you contributed. That means when you eventually withdraw money from the account during retirement, you’ve already ripped off the financial Band-Aid so to speak, and you have access to tax-free funds.

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Roth 401(k) eligibility

Employers aren’t required to offer any 401(k) plan. They’re an optional benefit businesses of any size can choose to provide, but there are no laws requiring employers to participate. If an employer does offer a Roth 401(k) option, they must also offer a traditional 401(k) plan. If both are offered, employees may split their contributions between the two options.

According to a retirement study by the Transamerica Center for Retirement Studies, 65% of U.S. workers have access to a 401(k) plan through their employer, with large companies (92%) being more likely to offer them than small businesses (59%). Of those companies offering a 401(k) plan, 45% offer the Roth 401(k) option. When offered the option of a Roth 401(k), approximately 28% of employees choose that option, with millennials choosing a Roth 401(k) option 63% of the time.

If your employer offers a 401(k) plan, it doesn’t automatically mean you’re eligible to participate. It’s up to each employer to determine which employees are eligible based on varying criteria. For example, only 41% of employers who offer a 401(k) plan offer it to their part-time workers. Other companies may require certain employment thresholds to be met before they can enroll (like being employed for a year).

Roth 401(k) deductions

Once enrolled in a Roth 401(k), a portion of your salary (usually a set percentage) is deducted automatically from each of your paychecks. For example, if you make $4,000 a month and decide to contribute 10% to your 401(k), then $400 will be deducted from each of your monthly paychecks.

Determining how that money is invested is up to each individual employee. Beyond the Roth option, in some cases, you will be presented with a variety of investment options including managed accounts and asset allocation suites. There may be a fee associated with some of them, which must be disclosed to employees by the plan’s administrator.

How much can you contribute?

There are no income limitations for participation in a Roth or traditional 401(k). However, there is a limit as to how much you can contribute, which is adjusted yearly. For example, in 2020, the limit is $19,500, while the limit for 2019 was $19,000. If you’re over the age of 50, you can contribute an extra $6,500 per year as a “catch-up” contribution. You don’t have to contribute the entire amount, but you can select to have any amount up to that limit deducted.

As much as 85% of companies who offer 401(k) plans also provide matching funds up to a certain amount, while others may contribute to your 401(k) regardless of whether you do or not. It’s important to note that any funds your employer contributes won’t be put in your Roth 401(k), and instead placed in a traditional 401(k). You will be responsible for paying taxes on the amount they contribute.

In some cases, employer contributions vest immediately, which means they belong to you right away, protecting your retirement in the event you quit or leave the company. In other cases, employer contributions are vested over time. That means if you quit before a certain amount of time, you only get to take a portion of the employer-contributed funds with you. The amount you get to keep typically increases each year, according to the employer’s vesting schedule, until you’re fully vested and get to keep the entire amount.

Roth 401(k) withdrawal rules

You’ve made the wise financial choice to invest in your future — so when do you get to use some of that money?

The money you’ve contributed, along with any vested employer contributions, technically belongs to you and you can withdraw it at any time. The catch is that unless you meet certain requirements, you’ll have to pay a penalty. To withdraw funds penalty-free, 59 and a half is the magic age. Once you’ve contributed to a plan for five taxable years and you hit your half birthday in your 59th year, you can withdraw from your fund without penalty.

If you do choose to withdraw funds from your 401(k) early, you’ll face a 10 percent early withdrawal fee on the amount, plus taxes. With a Roth 401(k) it’s a little bit different. Since you’ve already paid taxes on your contributions, you’re only responsible for paying the penalty tax based on the increase in the value of your funds since you opened the account. There are also exceptions for death or disability.

Some plans allow you to take out a loan from your Roth 401(k), but there are tax repercussions for doing so. You’ll pay interest on that amount and if you don’t repay the loan, the funds may be considered a non-qualified distribution, requiring you to pay taxes on that, too. In some cases, if you leave your job, you’ll be responsible for paying the loan in full at that time.

It’s important to note that you can’t leave the funds in a Roth 401(k) forever. The IRS requires that you take distributions from your plan no later than age 70 and a half, unless you’re still working.

Roth 401(k) vs. traditional 401(k)

In general, experts say the two most important factors to consider when deciding between a Roth and a traditional 401(k) is your age and the tax income brackets you’re currently in (and expect to be in later on). The more years between you and retirement, the more likely your Roth will pay off. That money has years to grow tax-free, and you won’t pay taxes on it no matter how much that money grows.

On the other hand, people who anticipate their tax rate will be lower in retirement may prefer to keep the extra income now and pay taxes in retirement. It’s not a cut-and-dry decision, and you must take into account your effective tax rates, expected earnings and various other factors that are unique to your situation.

If you can’t decide between the two, you can always split your contributions between both options to diversify your savings.

 Taxes2020 Contribution LimitsPenalty-free Withdrawal

Traditional 401(k)

Paid on funds when they’re withdrawn in retirement

$19,500 per year ($26,000 if you’re over 50)

After 5 years and at age 59 and a half or older (exceptions made for death and disability)

Roth 401(k)

Paid in the year funds are contributed to the plan

$19,500 per year ($26,000 if you’re over 50)

After 5 years and at age 59 and a half or older (exceptions made for death and disability)

Roth 401(k) rollover

As the saying goes, all good things must come to an end, and when you’re ready to move on from your job, you have some options when it comes to the funds you’ve been socking away.

One option is to leave it be and start a new 401(k) plan with your next employer. Many people, however, choose to transfer or “roll over” those funds into another account. While you can roll over your Roth 401(k) into a Roth IRA, you can’t roll it in into a traditional 401(k). On the flip side, you can roll over a traditional 401(k) into a Roth 401(k) or IRA, but you will owe taxes when doing so.

So, if you’re fortunate enough to work for an employer that offers a 401(k) plan, take a close look at your options. If Roth is one them, it’s worth considering to help secure your financial future.

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