The Roth 401(k): What Is It, and Should You Sign Up?

The Roth 401(k): What Is It, and Should You Sign Up?

You've heard of Roth IRAs and you've heard of 401(k)s.

Both are awesome in their own ways, but if you have a relatively new account called a Roth 401(k) available to you, you should definitely look into it, too.

Research shows that the Roth 401(k) is gaining in popularity: According to a 2014 study by Aon Hewitt, when a Roth 401(k) option is available, 11% of participants choose to contribute to it—up from 8.1% in 2011.

We'll break down the ins and outs of a Roth 401(k) retirement account, so you can be confident you're making the right decision for your finances. Even if you don't currently have one at your company, read on, because a Roth 401(k) can benefit many people, and you could always request that your HR department add it to the company's retirement options.

How Retirement Plans Differ

With a Roth IRA, you pay taxes on your contribution now, but then all the money you earn on it won't be taxed when you take it out, as long as you withdraw your money after age 59 1/2. The downside is that you can only put in $5,500 a year for 2016 ($6,500 if you're age 50 or older), and you have to earn below $117,000 in order to contribute the full amount if you're filing single or head of household. If you earn more than $132,000, you can't use a Roth IRA at all (but you can use a non-deductible traditional IRA). If you're married filing jointly, your income phase-out range is $184,000 to $194,000.

On the flip side, with a traditional 401(k), you don't pay taxes now, but then all your earnings are taxed when you take the money out, just like with the traditional IRA. The upside is that you can contribute up to $18,000 a year, or $24,000 if you're 50 or older.

But the Roth 401(k) offers the best of both worlds:

  • You pay taxes now so you don't pay taxes on any of your investment earnings. In other words, if you put in $15,000 and earn $100,000 on your investments over your lifetime, you're only taxed on that initial $15,000.
  • You can contribute up to $18,000 a year in 2016 ($24,000 if you're 50 or older).
  • There's no income limit, so even if you make more than $117,000 as a single filer or $184,000 as married filing jointly, you can still contribute that full amount.

In other words, you can go gangbusters on your retirement with a Roth 401(k).

But hey, if you're not comfortable contributing just $18,000 a year (you do, after all, have big plans for retiring in Monaco with access to a 40-foot sailboat), you can contribute even more. If you fall under the income limits mentioned above, you can also open your own Roth IRA, which means you can put up to $23,500 in your retirement accounts each year ($30,500 if you're 50 or older) and not pay taxes on however much that grows into when you retire. (If your income is too high to contribute to a Roth, then you can contribute to a traditional IRA, but the tax implications for those contributions would be different.)

Should You Sign Up?

Sounds perfect, right? It is pretty cool. But there are a few situations where you probably shouldn't take the option:

1. If your income is likely to drop a lot after you retire, or if your tax rate is high now. If you're in a scenario that makes you think you'll probably have a significantly lower income during retirement than you do today, that also means your tax rate might drop in retirement. For that reason, you might not want a Roth 401(k) where contributions are taxed now; you might instead want to defer your taxes and go with a regular 401(k).

2. If you don't have many years until retirement for your money to grow. One of the best benefits of the Roth 401(k) is that you are never taxed on investment gains. For this to be valuable, you'll want to have time for your money to really grow. As you get closer to retirement there is not only less time, but you often are taking a lot less risk with your portfolio, which usually translates to lower gains.

3. If you'll contribute less each month in order to make up for the loss in tax benefits you enjoyed under the traditional 401(k). There is a small upfront tax benefit in the traditional 401(k), in that every dollar you save actually lowers taxable income right now. While you still have to pay your taxes down the road (and even taxes on the investment gains), the Roth probably isn't the right fit just yet if you plan to put away less each month.

4. You want a broad array of investment options. Roth 401(k)s often offer narrower investment choices than Roth IRA accounts. If you care deeply about having lots of choices, this might give you pause.

The Bottom Line

Roth 401(k)s are a great option for almost every employee, especially those on the younger side who are looking to stash away as much as possible every year for a fantastic retirement.

*This article was updated on December 8, 2015.


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