The Roth 401(k): 8 Things You Need To Know

The Roth 401(k) is a retirement plan option that is becoming increasingly popular. Yet many people are asking themselves, "should I used a Roth 401(k)?" The answer is: it depends.

Let's start with the basics. A Roth 401(k) is similar to the Roth IRA in that it allows you to save after-tax money in a retirement account. Also like the Roth IRA, the money grows tax-free and can be withdrawn tax-free in retirement. This can be an awesome opportunity to allow your retirement money to grow tax-free and then be withdrawn tax-free after age 59 ½.

1. Should I save money in a Roth(k)?

There are four big draws for a Roth 401(k)

Withdrawals from a Roth 401(k) are tax-free. (Awesome!)

You don’t pay any taxes on capital gains or interest on money invested within the Roth 401(k).

Having a combination of Roth, Traditional tax-deferred and taxable accounts provides you with tax diversification in retirement. Tax diversification is financial planner fancy-talk for flexibility. It means you may be (better) able to control how much you pay in taxes during retirement. We can’t predict future tax rates or your future income but having some flexibility is generally a good thing.

If you roll your Roth 401(k) to a Roth IRA at retirement you won’t be required to take RMDs during your lifetime. Then if you properly set up your estate/tell your kids not to do anything stupid - your (named) beneficiary can take tax-free distributions over their lifetime, preserving the tax-free growth within the Roth IRA over two generations! Talk your estate planning attorney or financial planner for details.

2. Who can use a Roth 401(k)?

Anyone can use a Roth 401(k), as long as their employer offers it as part of their retirement plan options. If your employer doesn’t offer it, ask! From our experience running 401(k) plans, it’s an easy option to add.

3. How much can you save in a Roth 401(k)?

In 2018 you can contribute up to $18,500 in your traditional or Roth 401(k). You can save in both a traditional 401(k) and a Roth 401(k), but your combined contributions cannot exceed $18,000. One caveat - if you are over age 50 then you are eligible to make catch-up contributions of $6,000 per year. This means for those of you that are age 50+ you could save up to $24,000 across either type of 401(k).

4. How does the Roth 401(k) work?

Your employer will deduct money from your paycheck AFTER they take out deductions (i.e. health insurance or a traditional 401(k) and taxes. This is different from a traditional 401(k) - you will pay taxes on the money that you contribute to your Roth 401(k). Just like a traditional 401(k), you will have to choose from whatever investment options your employer offers.

5. Can I get an employer match on Roth 401(k) contributions?

Yes, your employer may offer a match on your Roth 401(k) contributions. However, the employer match has to be deposited into a pre-tax, traditional 401(k) account. This is an IRS rule, not your employer's.

6. What happens to my Roth 401(k) if I leave my employer?

If you leave your job you can either roll your money into your new employer’s Roth 401(k) or into a Roth IRA. Some employers offer plans that allow you to keep your money in the Roth 401(k) plan after you leave the company. Check with your HR department to find out if this is the case. Beware of high fees that may be lurking within your 401(k) should you decide to keep it there.

7. Does a Roth 401(k) have Required Minimum Distributions?

If you don’t roll your Roth 401(k) into a Roth IRA you will have to take Required Minimum Distributions. This is the same as the traditional 401(k) but an important difference from a Roth IRA. You can roll your money from your Roth 401(k) to your Roth IRA if you want to allow your money to continue compounding tax-free in retirement.

(psst, what’s a Required Minimum Distribution??)

Congress decided that retirement savers could only have so much tax deferral. (Tax deferral = less tax revenue) At some point, the federal government needs your tax dollars. This is where Required Minimum Distributions come in, or RMDs. Retiree’s have to take their first RMD by April 1st of the year following the calendar year in which they turn 70 ½. Don’t worry, the IRS has a complicated formula for you to use but there are calculators to help you figure out how much to withdraw. A fiduciary financial planner can keep you on track, too.

8. Ok, so why doesn’t everyone participate in a Roth 401k?

The biggest decision you have to make around whether to participate in a Roth 401k vs. (or combined) with a traditional 401(k) has to do with tax rates. Will your taxes be higher in retirement than they are today? Essentially, if your federal income tax rate is lower now than you expect it to be in retirement a Roth 401(k) could be a good option for you. Now you might be thinking:

Lauren, I have NO idea what my tax rate will be in retirement.

To which I would say, I totally agree. Here are two questions to think about that might help you make this decision.

Are you early in your career or do you have a ton of deductions (i.e. a mortgage and a whole slew of kids) that might be pushing your current tax rate down?
Do you already have a very large traditional 401(k) and are you looking to diversify the tax treatment of your retirement savings?

Another potential drawback, compared to a Roth IRA, a Roth 401(k) does have early withdrawal penalties. Just as with your traditional 401(k) if you withdraw money from your Roth 401(k) before you reach age 59 ½ you may be subject to a 10% penalty. Unlike a Roth IRA there is no exception for a first-time homebuyer, for qualified educational expenses or to pay health insurance premiums when you are unemployed.

We should also note: currently, a Roth IRA does not have RMDs. Congress could change that rule and start requiring RMDs from Roth IRAs. Congress could raise or lower taxes. That being said, I think it makes sense to plan based off of what we know to be true now. There are an infinite range of possibilities for the future.

Your financial plan is always a work in progress.

So, what am I doing?

Based on our current situation I believe we will be in a similar tax bracket in retirement. With that in mind we are currently splitting our retirement savings between tax-deferred 401(k)s and Roth IRAs. Your situation will be different but now you should have the information to make a better judgement for yourself, or at least know what questions to ask your financial planner.

This is general financial planning advice. It is not tax or legal advice. Please consult with your tax professional or financial planner before making any changes.