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). A Roth 401(k) shares its tax advantage with its older cousin from the other side of the family tree, the Roth individual retirement account (IRA).

These accounts play well together—you can use all three to grow your nest egg. First, though, you should explore the ins and outs of a Roth 401(k) and understand how it differs from other retirement plans. These critical details can help you decide whether contributing to a Roth 401(k) is a good option to financially safeguard you and your loved ones.

A Roth 401(k) operates much like a traditional 401(k). Once you enroll in an employer-sponsored plan, money from your paycheck automatically redirects into the account. However, you may need to work for a certain period of time at a company before you reach eligibility and can start participating. Your Roth 401(k) likely will offer a preselected menu of investment options, such as mutual funds or exchange-traded funds (ETFs), and your dollars will flow into the ones you choose at specific amounts you set.

Notably, you contribute after-tax dollars to your Roth 401(k). Your designated Roth contributions will be included in your gross income and are subject to wage-withholding requirements. If you follow the IRS's qualified withdrawal rules, your earnings will grow tax-free, so you won't need to pay taxes when you take out the money in retirement—more on that later.

This after-tax scenario marks the biggest difference between a Roth 401(k) and the traditional version: With a traditional 401(k), you contribute pretax dollars through payroll deductions. Accordingly, any taxes you pay are deferred until you begin withdrawals in retirement.

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 your golden years 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 recent 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.

If you still need a traditional 401(k) to benefit from an employer's 401(k) match, then why go through the trouble of having a Roth version at all? A big reason for this relates to the tax advantages.

You potentially could save money if you are in a lower tax bracket today than you think you'll be when you withdraw the money in retirement. The tradeoff of paying taxes up front for Roth contributions is that your potential gains generally fall into the "tax never" bucket. Other accounts in this category include municipal bonds and life insurance with cash value.

Why is this only usually true? It's because the scenario only goes as planned if you follow the IRS's withdrawal requirements.

Perhaps right now you're more concerned with contributions than withdrawals. That's absolutely understandable, but there are a few things you should know about making withdrawals as you work toward retirement and begin planning your golden years.

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 whenever you feel like it.

Withdrawals of contributions and 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

A Roth 401(k) allows you to take a partial distribution that draws from both your contributions and earnings on a prorated basis. This is different from the withdrawal rules for a Roth IRA, which draws from your contributions first.

In addition, through 2023 Roth 401(k)s have required minimum distributions (RMDs). This means you must begin taking money out of your account at your required beginning date (RBD) unless you're still working and aren't a 5% owner of the business sponsoring the plan. That said, each employer has the right to offer that delayed distribution option or not. SECURE Act 2.0 eliminates RMDs from Roth 401(k)s beginning 2024.

The IRS has announced that you'll be able to contribute more to a Roth 401(k) for 2023 than you would for 2022. That's thanks to an adjustment for cost-of-living increases due to rising inflation.

• For 2022, you can contribute up to $20,500 ($27,000 if you're 50 or older).
• For 2023, you can contribute up to $22,500 ($30,000 if you're 50 or older).

Traditional 401(k)s also have these contribution limits for 2022 and 2023. 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, taxes and penalties may apply.

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.
• 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.
• Employers can match your contributions (although the money will be allocated to a pretax account, and you'll pay taxes on it when you start taking distributions).

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 be a poor strategy 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.
• Your employer's Roth 401(k) plan could have high fees and expenses. Look for lower-cost investment options within the plan that can help you achieve your goals and that fit your risk tolerance.
• The withdrawal restrictions can be harsh. Roth 401(k)s are designed as long-term investment vehicles, which is why they impose a penalty for cashing out early. For quicker access to cash, you also might consider investing in more liquid assets like money market accounts.
• Since 401(k)s are employer-sponsored retirement plans, you'll have decisions to make if you leave your employer.

As this chart shows, a Roth 401(k) is a hybrid kind of retirement savings vehicle that shares features with other popular retirement plans.

Roth 401(k)s are offered through an employer, like traditional 401(k)s and 403(b)s, yet they're funded by dollars that already have been taxed, just like a Roth IRA. However, unlike a Roth IRA, a Roth 401(k) doesn't have income limits.

This chart shows how a Roth 401(k) compares to other tax-advantaged savings plans when it comes to making withdrawals and when required minimum distributions (RMDs) come into play based on your required beginning date (RBD):

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.