Considering a Roth 401(k)? Here's what you need to know

By now you may be pretty familiar with a 401(k), the employer-sponsored retirement plan that houses investments you fund through payroll deductions. But how much do you know about its younger cousin—the Roth 401(k)? It's another kind of perk offered by many organizations in the for-profit sector.

A Roth 401(k) can help you work toward your retirement savings goals, but it has a different kind of tax advantage than a traditional 401(k).  Let's explore the ins and outs of a Roth 401(k) so you can decide if it's a good option for you.

We'll cover:

• What is a Roth 401(k) & how does it work?
• Roth 401(k) contribution limits
• Do you have to choose between a traditional & Roth 401(k)?
• Roth 401(k) withdrawal rules
• Roth 401(k) benefits
• Roth 401(k) drawbacks
• How Roth 401(k)s compare to other retirement plans

A Roth 401(k) is a common type of employer-sponsored retirement plan. It helps employees save for and invest in their retirement in a tax-advantaged way.

When you sign up to participate in a Roth 401(k), you opt to have a specific percentage of your paycheck automatically directed into the plan. Your Roth 401(k) likely will offer a preselected menu of investment options, such as mutual funds or exchange-traded funds (ETFs), that your contributions will be invested in.

The most notable difference between a traditional 401(k) and a Roth 401(k) is the taxation. A traditional 401(k) is funded with pre-tax dollars, while the contributions you make to a Roth 401(k) already have been taxed so no additional tax liability will be incurred down the road. Earnings from a Roth 401(k) can be withdrawn tax-free if you make a qualified distribution.¹

Your employer has the option to match some or all of your contributions as an employee benefit, helping to give your savings a boost. Over time, your savings will compound and grow tax-deferred.

The IRS sets contribution limits for Roth 401(k)s each year. And if you're 50 or older, you can contribute over the limit through a catch-up contribution.

• For 2023, you can contribute up to $22,500 ($30,000 if you're 50 or older).
• For 2024, you can contribute up to $23,000 ($30,500 if you're 50 or older).

Traditional 401(k)s also have these contribution limits. If you have both types of accounts, those limits apply to your combined contributions. If you add money to both and accidentally surpass your annual contribution limit, you will have to remove the excess contribution, and taxes and penalties may apply.

If your company offers both kinds of 401(k)s, here's some great news: You can allocate some money to both types of account at any proportion you choose, within contribution limits of course.

Contributing to both a Roth and traditional 401(k) could be a smart strategy if you're looking for tax diversification, a key factor in retirement income planning. Making investment decisions with taxes in mind could increase the amount of money you have access to in retirement and allow you to make a greater impact with your savings.

You may be lucky enough to have an employer provide a partial or full matching contribution. As part of the SECURE Act 2.0 regulation, your employer can decide to give you the choice to allocate their match to the traditional or Roth side of your 401(k) account. Be sure to understand the tax implications of this selection and the impact on your retirement savings.

Doing taxes

Doing taxes

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Perhaps right now you're more concerned with contributions than withdrawals. However, there are a few things you should know about making withdrawals as you work toward retirement.

For one, plan to keep your dollars in a Roth 401(k) over the long term. It doesn't have the kind of flexibility that brokerage accounts do to take out your money as needed.

Withdrawals of earnings are only tax-free and penalty-free if your Roth 401(k) is at least five years old and one of the following requirements is met:

• You're at least age 59½
• You're disabled
• The money is being paid to a beneficiary

Through 2023 Roth 401(k)s were subject to required minimum distributions (RMDs). This means you must begin taking money out of your account at a specific age, as determined by your birth year.

However, SECURE Act 2.0 eliminates RMDs from Roth 401(k)s beginning 2024. That means if you don't need the money at your RMD age, you can leave it in the account to continue to grow indefinitely.

If your employer offers this kind of retirement savings account, here are some advantages that could make them worthwhile for you:

• Generous contribution limits.
• No income limits to participate.
• Paying taxes up front can be advantageous if you think you'll be in a higher tax bracket when you retire.
• You can borrow money from a Roth 401(k) if it's permitted in your plan; you would then repay it with interest.
• Withdrawals of contributions and earnings are tax-free and penalty-free if you meet the requirements.¹
• Employers can match your contributions.

Roth 401(k)s, like all investment vehicles, carry an inherent degree of risk. Your assets have the potential to lose value, but holding a diversified portfolio—meaning it has a mix of investments that tend to perform differently—can help mitigate your risk.

These savings accounts also have features you may view as potentially bothersome quirks or drawbacks.

• These accounts typically have a limited number of investment options. If you'd like more choices, you also may need to contribute to other retirement savings vehicles, like a traditional IRA or Roth IRA.
• Paying taxes up front may not be advantageous if you think you'll be in a lower tax bracket when you retire. That can be difficult to predict, however. If this is a concern, you could split your contributions between a Roth 401(k) and a traditional 401(k) to cover your bases and gain tax efficiency.
• Early withdrawals may carry penalties. Roth 401(k)s are designed as long-term investment vehicles, which is why they impose a penalty for early withdrawals. For quicker access to cash, consider supplementing with these options.
• Since 401(k)s are employer-sponsored retirement plans, you'll have decisions to make if you leave your employer.

A Roth 401(k) is a hybrid kind of retirement savings vehicle that shares features with IRAs. Let's compare to the traditional and Roth IRA.

What is a Roth 401(k)'s role in your long-term financial planning? Navigating all of these different account options and their related regulations can feel like a lengthy list. But it is entirely possible — especially with expert guidance. Connect with a financial advisor for all your retirement planning needs. Establishing the right mix of accounts now can help produce big benefits in the years to come, so don't hesitate to reach out for a helping hand.