401(k) Tips

Roth 401(k): Everything You Need to Know About It

A Roth 401(k) is a unique 401(k) that can help you save even more for retirement. Knowing everything about Roth 401(k)s you can maximize its potential and build wealth.

14 min read

When it comes to saving for retirement, there are many options to choose from. Most people that contribute to a retirement savings account do so through an employer-sponsored 401(k). However, there are even more options to stash money away for retirement. Another employer-sponsored retirement account is a Roth 401(k). It can be a great alternative to the traditional 401(k) while providing the same benefits and even more.

There’s no question that savings for retirement early and consistently help build a sizable nest egg to live off of throughout retirement. 401(k) plans provided by employers are a great way to automate retirement savings, take advantage of employer contributions, and enjoy the tax advantages.

Getting creative and utilizing different variations to the traditional 401(k) can help maximize the benefits each retirement account provides.

Because Roth 401(k)s are a little less common, let’s take a deep dive into this unique retirement savings account. You’ll learn everything you need to know so you can decide if a Roth 401(k) is the right addition to your retirement savings portfolio.

What is a Roth 401(k)?

A Roth 401(k) is similar to a traditional 401(k). However, Roth 401(k)s have some features that are a little different.

Roth 401(k)s are a designated retirement account. Contributions are taxed initially, but no taxes are paid during retirement. Because Roth 401(k)s are retirement accounts, the money must stay put until retirement.

Provided by an employer-sponsored retirement savings plan, a Roth 401(k) is intended to build wealth to live off of throughout retirement. Contributions are automatically taken out of employees’ paychecks which ensures consistency.

However, contributions are made using after-tax dollars. Meaning, when employers dish out paychecks, taxes are taken out first. Then the elected contribution percentage is taken out of the remaining amount. This method leads to less money being contributed to a Roth 401(k), but there is a plus side to doing it this way.

When distributions are taken out during retirement, taxes will not be deducted. This can be pivotal for retirees wanting to maximize the amount of money they keep during retirement.

Another bonus is that employers can still match contributions made to a Roth 401(k). However, when employer contributions are taken out during retirement, this amount will be taxed at the retiree’s income tax bracket.

The Roth 401(k) is growing as a more favorable method to saving for retirement. Mainly for the reason that the money employees contribute and its growth can be taken out tax-free!

Roth 401(k) vs. Traditional 401(k)

It’s only logical when looking into Roth 401(k)s to compare them against the traditional 401(k). We’ve just covered what a Roth 401(k) is; let’s briefly go over traditional 401(k)s.

We’re pretty familiar with the traditional 401(k). Contributions are made with pre-tax dollars, which helps lower the tax burden during our working years. A more considerable amount is saved each paycheck. However, that money that’s contributed—and its growth—will be taxed when it is distributed during retirement. Additionally, employers can match contributions, and that amount will also be taxed when withdrawn.

Looking at Roth 401(k)s vs. traditional 401(k)s, the glaring difference is the tax situation. Traditional 401(k)s aren’t taxed immediately but pay taxes during retirement. Roth 401(k)s pay taxes initially, but distributions aren’t taxed during retirement.

Those choosing which one needs to decide whether they want to be taxed first or wait and be taxed during retirement.

By choosing to pay taxes now, you’re getting your tax burden out of the way. However, by delaying taxes for decades down the road, it’s impossible to predict what the tax and economic situation will be. Rising national debt, inflation, and any other factors that can affect what tax burden we’ll face in the future will have an impact on the money you’ll keep during retirement.

Roth 401(k) vs. Roth IRA

Roth 401(k)s often get confused with Roth IRAs. Both retirement accounts are funded using after-tax dollars, helping them enjoy the same tax-free withdrawals during retirement. However, there are a few main differences between the two accounts.

Roth 401(k)s are provided by an employer-sponsored plan, while Roth IRAs are held by outside institutions. Roth 401(k)s can take advantage of an employer match and have higher contribution limits than Roth IRAs. Additionally, Roth 401(k)s also don’t have any income limits and much more investment options compared to Roth IRAs.

Roth IRAs are administered by outside institutions, unlike Roth 401(k)s that are held by employer-sponsored plans. This difference means that Roth IRAs don’t come with employer contributions. Having an employer matching the contributions made to a retirement account, you can double the amount you’re contributing to your retirement.

Income Limits

The first significant difference between who can contribute to a Roth 401(k) and a Roth IRA is their income limits.

The IRS limits who can contribute to a Roth IRA to those whose adjusted gross income is $140,000 individually and $208,000 combined for married couples. If you contribute to a Roth IRA and end up making more than the limit, the contributions will incur a 6% penalty for each year until it is corrected.

Roth 401(k)s do not have such income limits. No matter how much you make, you can contribute to a Roth 401(k) so long as your employer provides one in their 401(k) plan.

Contribution Limits

Another significant difference between Roth 401(k)s and Roth IRAs is the amount you can contribute. Roth IRA contributions are limited to just $6,000 per year as of 2021, with an additional $1,000 allowed for those over 50.

The annual contribution limits for Roth 401(k)s on the other are $19,500 in 2021, with those over 50 allowed to contribute an additional $6,500. Additionally, the contribution limits for Roth 401(k)s are tied to individuals, not plans. Meaning if you contribute to a traditional 401(k) plan in addition to a Roth 401(k), you cannot exceed $19,500 (or $26,000 if you’re over 50) in total contributions to both retirement accounts.

Investment Options

Lastly, employer-sponsored 401(k) plans have a set menu of investment options to choose from. The average 401(k) plan offers about 19 different investment options, including target-date funds, index funds, mutual funds, and bonds.

Because Roth IRAs are held by outside institutions, there are seemingly endless options to invest your money. Roth IRAs can be invested in index funds, mutual funds, and even individual stocks.

More savvy retirement savers may enjoy the broader array of investments to grow their money more.

How do Roth 401(k) Withdrawals Work?

As mentioned previously, the main benefit of saving for retirement through a Roth 401(k) is that withdrawals are made tax-free. Because taxes were paid on the amount that was contributed, the tax obligation has already been met.

However, according to the IRS, withdrawals can still be subject to taxes and penalties if they do not qualify.

To make a "qualified" withdrawal from a Roth 401(k), the account must have been contributed to for at least the previous five years and the account holder must be at least 59½. Also, withdrawals can be taken if the account holder becomes disabled or after the death of an account owner, in which case the funds would go to the beneficiaries of the account.

Withdrawals from a Roth 401(k) will be exempt from any taxes penalties if the account has been contributed for the past five years, and:

  • The account owner becomes permanently disabled;
  • After the death of the account owner;
  • Or after the account owner is 59½.

Taxes on Non-Qualifying Withdrawals

If a Roth 401(k) account withdrawal does not meet the IRS’s above criteria, it is considered an unqualified withdrawal. You can withdraw contributions from a Roth 401(k) without paying taxes or penalties since Roth contributions are made with after-tax dollars. However, if the withdrawal is not qualified, you’ll pay taxes on any growth earnings you withdraw and be subject to a 10% early withdrawal penalty.

Early withdrawals are prorated between the non-taxable contributions and the growth. To calculate the portion of the withdrawal correlated to growth, multiply the withdrawal amount by the ratio of total growth to the account balance. For instance, if your account balance is $100,000, and you contributed $90,000 and earned $10,000, then the earnings ratio is 0.10 ($10,000 / $100,000).

In this case, a $15,000 withdrawal would include $1,500 in taxable earnings, which would need to be reported in your gross annual income to the IRS come tax time.

Roth 401(k) Tax Deductions

One of the best features of the Roth 401(k) is there are no tax deductions on distributions taken during retirement. Every last dollar that is in your Roth 401(k) after 59½ will go right into your pocket.

Since taxes were already taken out of the money before it was contributed to the Roth 401(k), all tax obligations were met.

However, this means the dollar-for-dollar contributions in comparison to a traditional 401(k) are smaller. But the growth and nest egg you’ll enjoy during retirement will not be subject to whatever tax bracket you find yourself in decades in the future.

Roth 401(k) Employer Match

Perhaps the best feature of either employer-sponsored 401(k) plans is the opportunity to have the employer contribute to the 401(k) as well. By receiving matching contributions to a 401(k), you can instantly double the amount of money being saved for your retirement at no additional charge to you.

For Roth 401(s), employers can match a certain percentage of the employee’s after-tax contributions. However, the employer’s matching contribution goes into a traditional 401(k), while the employee’s contributions go into the Roth 401(k).

If your employer offers to match contributions to their traditional 401(k)s, they most likely match contributions made to a Roth 401(k). You can find clarification in your 401(k)’s summary plan description or by asking your plan’s administrator.

According to a Bureau of Labor Statistics survey, about half of employers who offer a 401(k) match their employees’ contributions. Additionally, the average amount employers match is 3% of the employee’s salary.

Remember, while your Roth 401(k) contributions and growth are not taxed when they are withdrawn during retirement, the matching contributions your employer made will be because your employer did not pay taxes prior to contributing money to your Roth 401(k).

Roth 401(k) Rollovers

When saving for retirement, you’re stashing away money to use during retirement. And since retirement could be decades away, you’ll need to keep track of this money for a long time.

Unfortunately, due to the amount of job and career changes (about 12 times before 40) many Americans experience during their working years, a large amount of retirement money gets left behind. As a result, billions of dollars in retirement savings go unaccounted for.

Rolling over old Roth 401(k)s to your current Roth 401(k) or other retirement accounts ensures your retirement savings are monitored in one place.

If you left a job with more than $5,000 in your Roth 401(k), most employers would allow you to retain the account indefinitely.

If you leave with less than $5,000 but more than $1,000, your former employer may roll over your Roth 401(k) into an IRA of their choosing.

Roth 401(k)s left behind with less than $1,000 may be cashed out and sent to the former employer via check. This amount will still be subject to taxes and penalties as it is classified as an unqualified withdrawal.

In any event, your former employer is required to notify you of any action they take regarding your Roth 401(k).

To avoid anything happening to your Roth 401(k) that you don’t want to happen, be sure to roll over your Roth 401(k) after you leave your employer.

Roth 401(k) to Roth IRA Rollover

The process of rolling over a Roth 401(k) to a Roth IRA is relatively simple. In fact, it’s the same process as rolling over a traditional 401(k) to a traditional IRA.

If you don’t already have a Roth IRA, you’ll need to open one with any institution that offers a Roth IRA. Then, you’ll need to contact your Roth 401(k) plan’s administrator or your human resource department and tell them you’d like to roll over your Roth 401(k) to your Roth IRA. You’ll need to provide them with your Roth IRA account information, and they’ll facilitate the transfer for you.

The Five-Year Rule

Just like Roth 401(k)s, Roth IRAs are contributed to with after-tax dollars. In return, distributions during retirement are not taxed. Additionally, withdrawals made before retirement are not taxed as Uncle Sam has already received his cut.

One caveat to this is the IRS’s five-year rule that pertains to Roth IRAs. A Roth IRA must be open and active for at least five years in order to make early retirement withdrawals and avoid any taxes and penalties. Meaning, the Roth IRA must be actively contributed to for at least five years prior to making any withdrawals.

If you’ve had both your Roth 401(k) and Roth IRA open for at least five years, no problem. You can rollover your Roth 401(k) into your Roth IRA and take early distributions. However, if you recently opened a Roth IRA to roll over your Roth 401(k), you’ll need to wait until the Roth IRA is five years old to make any withdrawals penalty-free, even if your Roth 401(k) has been opened longer than five years.

This is important if your main goal of rolling over your Roth 401(k) to a Roth IRA is to take early retirement distributions.

Why You Would Rollover a Roth 401(k) to a Roth IRA

There are two main reasons why you would want to roll over your Roth 401(k) to a Roth IRA.

First, as mentioned previously, employer-sponsored 401(k) plans are limited in the types of investment options they provide. Compared to the endless options major institutions like Fidelity and Vanguard provide, 401(k)s leave a lot to be desired.

Second, 401(k)s—Roth 401(k)s included—are subject to required minimum distributions (RMDs) starting at 72. Roth IRAs are not required to take required minimum distributions at all. If you’re looking to avoid having to withdraw money from your Roth IRA once you turn 72, rolling over your Roth 401(k) is an excellent idea.

401(k) to Roth 401(k) Rollovers

If you’ve been contributing to a traditional 401(k) for some time now and realize you’d like to receive tax-free withdrawals during retirement instead, it’s not too late.

You can rollover your traditional 401(k) balance over to a Roth 401(k) if your employer’s plan offers Roth 401(k)s. You can also keep your employer’s matching contribution amount and apply it to the Roth 401(k). It’s important to remember, however, when rolling over a traditional 401(k) to a Roth 401(k), taxes will be due on the balance being rolled over.

You’ll still have access to the same investment options you had under your traditional 401(k). However, you may need to reallocate the funds to your preferred investment option if it’s different from the plan’s default investment option.

Another thing to keep in mind when rolling over a traditional 401(k) to a Roth 401(k) is the tax implications. You contributed to your traditional 401(k) with pre-tax earnings, and the growth and distributions from your Roth 401(k) will be tax-free. Because of this, you’ll need to pay taxes on the entire amount you roll over from your traditional 401(k) to your Roth 401(k).

For example, say you roll over $100,000 from your traditional 401(k) to your Roth 401(k), and you’re in the 22% tax bracket. You will have to forfeit $22,000 from your traditional 401(k) balance for tax purposes.

It may seem like a harsh price to pay, but most likely, you’d have a similar amount in your Roth 401(k) had you been contributing to one all along. Going forward, you can rest easy knowing you’ve gotten your tax burden out of the way and won’t have to pay taxes on the amount during retirement.

What is a Mega Backdoor Roth 401(k)?

The IRS limits total contributions to traditional 401(k)s and Roth 401(k) to $58,000, or $64,500 for those over 50.

This limit includes contributions made by employees and those made by employer’s matching contributions. Remember, the contribution limit for Roth 401(k)s is $19,500, or $26,000 if you’re older than $50,000.

A mega backdoor Roth 401(k) provides employees a way to contribute more towards a Roth 401(k). By utilizing this strategy, you can contribute a total of $38,500 towards a Roth 401(k).

Your plan must allow for “after-tax contributions” in order to take advantage of the mega backdoor Roth. After-tax contributions don’t count toward the $19,500 limits ordinarily set by the IRS.

Let’s take a look at a basic example of how a mega backdoor Roth 401(k) works. Say you make $100,000 annually before tax. You’re maximizing your 401(k) by contributing $19,500. Your employer offers to match 100% of your contributions, up to 3% of your salary, equally $3,000 per year. Taking the $58,000 maximum contribution limit and subtracting the $19,500 you contributed and the $3,000 your employer matched, you can contribute an additional $35,500 in after-tax contributions to your Roth 401(k). If you don’t receive a match from your employer, you can contribute $38,500 to your Roth 401(k).

In most instances, a mega backdoor Roth 401(k) makes sense for very high earners. Otherwise, it may make more sense to maximize the entire $19,500 allotted towards a Roth 401(k) and maximize the $6,000 towards a Roth IRA first. You’ll reap the tax-free growth and distribution benefits without having to jump through as many hoops aiming for the mega backdoor Roth 401(k).

Roth 401(k) Loans

If you need to withdraw your Roth 401(k) funds but don’t have a Roth IRA to roll over to and you need more than the after-tax amount will leave, there is still one way you can withdraw funds from a Roth 401(k) in a pinch.

A Roth 401(k) loan is a loan taken out against your Roth 401(k) account. Like traditional loans, principal (the balance borrowed) and interest must be repaid to your Roth 401(k) account within five years.

If your 401(k) plan allows for it, Roth 401(k) loans are a great way to access your retirement funds without diminishing your reserves long term. The terms of the loan will be established in the 401(k)s summary plan description. There you’ll find things like maximum loan amounts ($50,000 or 50% of the account balance, whichever is less), interest rates, and repayment terms (typically five years).

The principal and interest you payback on the loan will be sent right back to your Roth 401(k) account. Thus, replenishing what you took out initially.

However, defaulting on your Roth 401(k) loan will trigger early withdrawal taxes and penalties.

Additionally, if you leave your employer with a Roth 401(k) loan outstanding, you may need to repay the remaining balance of the loan within 60 days.

There’s a lot to consider before taking out a Roth 401(k) loan. However, if you need access to your funds and avoid taxes and penalties, it can be a great option.

Roth 401(k) Required Minimum Distributions (RMDs)

A common misconception about Roth 401(k)s is that they do not require minimum distributions like Roth IRAs. While Roth IRAs don’t require distributions be taken out, Roth 401(k)s must begin taking distributions once the account holder turns 72.

A required minimum amount must be distributed from a Roth 401(k) each year to avoid penalties charged by the IRS.

To calculate the required minimum distribution amount from your Roth 401(k), divide your 401(k) balance as of December 31 of the previous year by your life expectancy factor.

Your life expectancy factor is taken from the IRS Uniform Lifetime Table.

An exception to this requirement is that if your spouse is the only primary beneficiary and is ten years younger than you, use the IRS Joint Life Expectancy Table instead.

Failure to withdraw the required minimum distribution and the amount that is left in the Roth 401(k) will be subject to a 50% penalty. Meaning if you were required to withdraw $10,000 the previous and don’t, you could lose $5,000 automatically.

The IRS does allow some exceptions to RMDs. If you’re 72 and older and still working for the company that sponsors your 401(k) plan and don’t more than 5% of that company, you can delay your mandatory withdrawals.

However, if you leave that company, you will be required to begin taking mandatory withdrawals from that 401(k) plan.

Additionally, this exception only applies to the 401(k) plan held by that employer. Any old 401(k)s with former employers you still have are subject to mandatory withdrawals.

To avoid having to deal with required minimum distributions altogether, you can rollover your Roth 401(k) to a Roth IRA. Roth IRAs don’t require any minimum distributions ever.

What is a Solo Roth 401(k)?

Those who are self-employed, freelancers, or small business owners don’t have the benefit of joining an employer-sponsored 401(k) plan. However, there is still an option for entrepreneurs to save for retirement through a Roth 401(k). Enter the Solo Roth 401(k).

A Solo Roth 401(k) is a retirement account designed for small business owners, entrepreneurs, and self-employed individuals. Account holders can contribute after tax income to a Solo Roth 401(k), while employer contributions are put into a regular Solo 401(k).

The only eligibility limitation is that the business has no full-time employees. The Solo Roth 401(k) can cover both the account holder and their spouse.

The same total contribution limit of $58,000 for traditional and Roth 401(k)s also applies to Solo Roth 401(k)s. However, you can contribute to a Solo Roth 401(k) both as the employee and the employer. Your employee contributions are limited to $19,500. Your employer contributions are limited to 25% of your compensation or net self-employment income, which is equal to your net profit minus half your self-employment tax and the plan contributions you made for yourself.

A great benefit of the Solo Roth 401(k) is contributions made by the “employee” are taxed up front. They then grow and are distributed during retirement tax-free. Additionally, because contributions made by the “employer” are made pre-tax, they reduce the business’s tax obligations.

Because you don’t have the structure of an employer-sponsored 401(k) plan, a Solo Roth 401(k) must be opened by a brokerage or other outside institution. You’ll need your business’s tax EIN to open a Solo Roth 401(k); however, you’ll enjoy the full spectrum of investing options.