Who benefits from a Roth 401K?

If you have heard about a Roth 401(k), you may want to know how it compares to a traditional 401(k). A Roth 401(k) combines the features of a Roth IRA and traditional 401(k), and it is offered through the employer. It is funded by after-tax money, and you won’t pay taxes on distributions taken in retirement. A Roth 401(k) may be desirable to workers who want to avoid taxes in retirement.

Younger workers with lower wages and a lower tax rate stand to benefit more from a Roth 401(k) than older workers. A Roth 401(k) makes sense for millennials since they expect to earn more money as they move up their careers and in retirement. By paying taxes now, the money grows tax-free, and you won’t pay taxes on distributions taken in retirement.

Why Roth 401(k) Make Sense for Millennials

Younger workers who are starting their careers stand to benefit more from a Roth 401(k). These workers tend to be in a lower tax bracket, and they expect to be bumped up to a higher tax bracket as they age and earn more money.

The contributions you make to a Roth 401(k) are taxed upfront. You will enjoy decades of tax-free compounding of your retirement savings, and take tax-free distributions in retirement when you would otherwise be in a higher tax bracket.

If you are considering either Roth 401(k) or Roth IRA, a Roth 401(k) would take the lead for several reasons. A Roth IRA has no income limits, and you can contribute to the plan regardless of how much you earn. However, with a Roth IRA, there are income limits, you may not be allowed to contribute to the account if your income exceeds a certain limit. Also, a Roth 401(k) has higher contributions limits than a Roth IRA. For 2022, you can contribute $20,500 to a Roth 401(k) or $27,000 if you are above 50, while contributions to a Roth IRA cannot exceed $6,000 in 2022, or $7000 if you are above 50.

How Roth 401(k) Works

An employer may offer a traditional 401(k) or Roth 401(k) to its employees. A traditional 401(k) is the most popular type of 401(k), and it gives employees an immediate tax break on their contributions. Employers may also offer a Roth version of 401(k) for employees who want to enjoy tax-free distributions in retirement.

Once you enroll in a Roth 401(k), you contribute after-tax money to the plan, and the funds grow tax-free over your working years. You won’t get a tax deduction on Roth 401(k) contributions. However, once you retire, you can take distributions from the account tax-free.

Also, unlike a Roth IRA that has income limits, there are no income restrictions for employees contributing to a Roth 401(k). As long as you are eligible to participate in the employer's Roth 401(k) plan, you can contribute to the retirement plan regardless of your annual income.

If the employer offers both traditional 401(k) and Roth 401(k), you can decide to contribute to both retirement plans. However, the contributions to both types of 401(k)s cannot exceed $20,500 in 2022, or $27,000 if you are above 50.

Benefits of Roth IRA

No income limit

Roth IRAs do not have an income limit, and this means everyone, including high-income earners, can contribute to a Roth 401(k). This makes a Roth 401(k) more attractive than a Roth IRA, which limits high-income earners from contributing to the account. Also, you can contribute up to $20,500 for 2022, and an additional $6,500 if you are age 50 or older.

Employer contributions

If you have a Roth 401(k) with your employer, you can receive matching contributions from your employer. However, since the Roth 401(k) is funded with after-tax dollars, and employers match contributions with pre-tax dollars, the matching contributions will be deposited in a traditional 401(k).

Roth 401(k) loans

Unlike a Roth IRA that does not allow loans, you can borrow from a Roth 401(k) to meet urgent financial needs. You may be allowed to borrow 50% of the Roth 401(k) balance or a maximum of $50,000, whichever is lesser. You must pay off the loan in equal installments over the loan period, or make several lump-sum payments to pay off the loan.

Tax-free distributions

Since a Roth 401(k) is funded with after-tax money, you won't owe taxes when you take qualified distributions from the account. You can take qualified withdrawals if are age 59 ½ or older and have held the Roth account for at least five years. If you are 59 ½ but you have held the account for less than 5 years, you will owe income taxes on any distributions you take from the account.

Drawbacks of Roth 401(k)

Requires RMDs

Once you reach 72, you must start taking the required minimum distributions from your Roth 401(k). If you don't take the mandatory distribution, you will be required to pay up to a 50% penalty on the distributions not taken. The only exemption is if you are still working at age 72 and you don't own more than 5% of the company.

Limited investment options

With a Roth 401(k), you can only invest your retirement money on the investment options provided by the plan. Unlike a Roth IRA, you don’t have access to a wider pool of investment options; you are only limited to stocks, bonds, and mutual funds.