LAST REVIEWED Feb 17 2020 15 MIN READ
By Damian Davila
401(k)s are a widely popular option for American workers who are saving for retirement. However, many aren’t even aware that they have an option between two versions of this employee-sponsored plan: a pre-tax traditional 401(k) and a post-tax Roth 401(k).
Both of these plans offer a way to save money for retirement, so let's figure out whether saving with pre-tax or post-tax dollars is best suited for your current financial situation, and how you may be able to make the most out of a Roth 401(k).
What is a Roth 401(k), and how is it different than a traditional 401(k)?
Roth 401(k) = after-tax dollars
Traditional 401(k) = before-tax dollars
Unlike a traditional 401(k), a Roth 401(k) can only be funded with post-tax money. While employees contributing to a Roth 401(k) may feel the pinch upfront, they will be happy to know that their contributions will grow tax free forever. That’s right, Uncle Sam won’t be able to apply income taxes once you’re ready to withdraw your funds during retirement, like he would with your traditional 401(k) funds.
As a matter of fact, you aren’t liable for any income taxes for withdrawals of your contributions as long as you have held your balance for at least five years in your Roth 401(k) and are at least 59 1/2 years old. Keep in mind, you’ll still be liable for applicable income taxes and 10% penalty from the IRS for non-qualified distributions if you withdraw early (i.e. the funds you didn’t contribute directly). Still, you'll be paying taxes on a much smaller portion.
For example, if you were to have a Roth 401(k) balance of $12,000 made up of $9,000 in contributions and $3,000 in earnings, you would have an account’s earnings ratio of 25%. If you were to withdraw $1,000 before age 59 1/2, you would only pay income tax and penalty tax on the $250.
Human Interest lets employers offer both Roth 401(k) and a traditional 401(k). For more information, feel free to get in touch!
Is a Roth 401(k) a good fit for me?
So, who can benefit the most from holding a Roth 401(k) vs. a traditional 401(k)? See if you meet any of the criteria below:
You’re just starting out your career
Whether you’re holding a summer job in high school, working a part-time gig during college, or landing your first job after finishing university, you’re most likely to be in the lowest tax bracket that you’ll ever be. In that case, it makes a lot of sense to take the income tax upfront and let those contributions grow tax-free forever. While it may be true that you'll feel more pressure on your budget right now, your future self will thank you.
As the years go by, you’ll eventually advance in your career, make more money, and move up to higher income tax brackets. Using the 2017 single taxable income tax brackets, if you were to make $30,000 per year, you would pay an estimated $4,047.25 in federal taxes. With a salary bump to $55,000, you would pay an estimated $9,488.75 instead. Assuming that you would need around $55,000 per year during retirement for comfortable living, it would make financial sense to pay income taxes on retirement savings earlier and put that money in a Roth 401(k).
Your career path has considerable income growth potential
There are certain careers in which you can reasonably expect your annual income to consistently grow over the years. In 2015, the median annual wage for a lawyer in the finance and insurance industries was $144,050 and in 2014, the median annual wage for an anesthesiologist was $443,859. As pointed out earlier, if you're going to make more money in the future, you would benefit from paying income taxes on retirement funds earlier. In that case, most of these individuals would choose between a Roth IRA and Roth 401(k).
Roth 401(k) vs. Roth IRA
There are two reasons why an individual would benefit more from a Roth 401(k) than a Roth IRA (though you can certainly contribute to both, if you qualify!).
First, a Roth 401(k) has a higher contribution limit. In 2017, a U.S worker can only contribute up to $5,550 ($6,500 if age 50 or over) to a Roth IRA. On the other hand, that person could contribute an extra $12,500 ($17,500 if age 50 or over) to a Roth 401(k) in the same year.
Second, contributions to a Roth 401(k) aren’t subject to the income limitations like those to a Roth IRA. In 2017, single filers, heads of household, or married individuals filing separately making under $118,000 can contribute up to $5,500 to a Roth IRA. Those making anywhere from $118,000 to $132,999 can contribute a reduced amount and those making over $133,000 aren’t allowed to make any contributions to such a retirement account. Check IRS Publication 590-A for the full list of contribution rules for Roth IRAs.
You’ve maxed out contributions to another type of Roth account: IRA, 403(b), or 457(b)
If you’re looking to maximize your retirement savings with after-tax dollars, then keep in mind that you can contribute to a Roth 401(k) even after having maximized your contributions to another type of Roth retirement account, such as a Roth IRA, 403(b) or governmental 457(b).
For example, in 2017 you can contribute up to $5,500 ($6,500 if age 50 and over) to a Roth IRA and then continue to contribute up to $18,500 ($24,500 if age 50 and over) to a Roth 401(k), starting in 2018.
You plan to retire early
According to the 2017 data from the EBRI’s Retirement Confidence Survey, 3% of workers age 25-34 and 17% of workers age 35-44 have $250,000 or more in savings and investments for retirement. For these individuals, it might be financially feasible to retire or semi-retire before the traditional age of 65.
With a Roth 401(k), a retirement saver has the flexibility to start making tax-free withdrawals as early as age 59 1/2, as long as contributions have remained in the account for at least five years. Since you contributed to your Roth 401(k) with after-tax dollars, you don’t have to pay any income taxes on those withdrawals. If you would like to learn more about early retirement, read our overview on Financial Independence: Early and Semi-Retirement.
You plan to work past age 70 1/2
With a Roth 401(k), you can delay your required minimum distributions (RMDs) past age 70 1/2 by rolling your balance to a new employer-sponsored retirement account. An RMD is the amount that a 401(k) holder must begin withdrawing from their retirement account by April 1st following the year they reach age 70 1/2. To calculate your RMD, divide your account balance as of the end of the immediately preceding calendar year by a distribution period from the IRS’s “Uniform Lifetime Table.” Learn more about RMDs on this section of the IRS’s website.
When looking to defer your RMD’s with a Roth 401(k) rollover, you can only rollover to a Roth 401(k) or Roth IRA. Depending on how much you’re expecting to earn and to continue saving for retirement, you would decide between those two accounts at the time of the rollover.
Review our guide on comparing Roth 401(k) vs. Traditional 401(k).
Best practices for Roth 401(k) holders
Plan ahead for employer matches (they’ll always be pre-tax!)
Even when holding funds in a Roth 401(k), all of your employer contributions to your retirement account (AKA your company match) must go into a traditional 401(k). This means that those employer contributions are made with pre-tax dollars and will be subject to income taxes when you make withdrawals in retirement, even if you decide to put your own contributions into a Roth 401(k). Remembering that you have a traditional 401(k) in addition to your Roth 401(k) is key when separating from your employer and planning to rollover your nest egg. To learn more about rollovers, review How to Roll Over Your 401(k).
Keep track of the balances that are available for withdrawal
In order to not be subject to income tax, contributions and earnings must have stayed in the Roth 401(k) for at least five years. And to avoid the 10% early withdrawal penalty, those amounts can only be withdrawn starting at age 59 1/2. When used correctly, a Roth 401(k) can provide the option to tap into retirement funds at a lower cost and earlier than retirement. Depending on your unique financial situation and retirement strategy, this feature could give you some much needed flexibility.
Be aware of rollover rules past age 70 1/2
Here are some rules when considering a Roth rollover at age 70 1/2 to delay RMDs:
You can only do a Roth 401(k) rollover at age 70 1/2 when you don’t hold more than 5% stock in the company sponsoring the original plan.
If rolling over to a Roth IRA, the start date of the Roth IRA becomes the beginning of the mandatory five-year holding period for qualified distributions.
Get full disclosure of all costs and tax implications of doing a rollover. This will be difficult to do, because providers often make it as difficult and opaque as possible for you when you want to move money away from them, but be insistent and ask for all of the details.
If you have employer contributions in a traditional 401(k), you will have to choose one of the following options: taking RMDs, converting the balance to Roth 401(k), cashing out a portion and paying the applicable income tax, or doing a mix of some or all of these. Consult your financial advisor for more details. Don’t have one? Here is a
to prepare for that meeting.
Moving pre-tax 401(k) funds to an after-tax 401(k): A conversion
If you’re a holder of a traditional 401(k) and believe that you would benefit from switching to a Roth 401(k), you now have the option of converting your plan assets. The Small Business Jobs Act of September 2010 enabled retirement savers to convert their non-Roth balances in tax-qualified retirement plans into Roth balances, as long as their employers offered the option.
Prior to this Act, the only option for retirement savers was to take a distribution and put those monies into a Roth IRA. Consult your plan administrator to determine whether or not you have the option to convert to a Roth 401(k) and learn what the applicable costs would be. Yes, remember that there costs to convert to a Roth 401(k), so time your conversion with a tax year chock full of deductions to offset those costs.
If your current employer-sponsored plan doesn’t offer the option to switch to a Roth 401(k), let them know about Human Interest, which offers Roth 401(k) plans.
Damian Davila is a Honolulu-based writer with an MBA from the University of Hawaii. He enjoys helping people save money and writes about retirement, taxes, debt, and more.