What is a Roth 401(k)?

401(k), Banking Basics, Investing, Retirement Planning
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A 401(k) is key to many retirement nest eggs, but about half of plan sponsors now offer a second option: a Roth 401(k).

What are the benefits of a Roth 401(k)?

The Roth 401(k) brings together the best of a 401(k) and the much-loved Roth individual retirement account. It features:

  • The 401(k)’s annual contribution limit of $18,000, or $24,000 for those 50 or older
  • No income rules for eligibility, also from the 401(k)
  • The Roth IRA’s after-tax contributions, so qualified withdrawals are tax-free

It can be hard to turn your back on those attributes, but is a Roth 401(k) suitable for you? Here are the factors to consider.

More money now vs. later

First up: your current cash-flow needs and the after-tax value of these accounts in retirement. Contributions to a Roth 401(k) can hit your budget harder today because an after-tax contribution takes a bigger bite out of your paycheck than a pretax contribution to a traditional 401(k). So it may cost you more on the front end to use a Roth 401(k).

On the back end, however, the Roth account can be more valuable in retirement. That’s because when you pull a dollar out of that account, you get to put that entire dollar in your pocket. When you pull a dollar out of a traditional 401(k), you can keep only the balance after paying taxes on the distribution.

Contributing the maximum allowed to either account each year will yield the same pot of money in retirement. The traditional 401(k) balance would then be reduced by your tax rate in retirement, whereas the Roth 401(k) balance would remain whole.

To even that score, you’d need to invest the value of the tax savings gained each year from contributing to a traditional 401(k). If you put $5,000 into a traditional 401(k), yielding a tax savings of $1,250, and then put that $1,250 into an investment account each year, it would make the upfront cost of the Roth and traditional 401(k) comparable. That would allow you to make a direct comparison based on the next factor: tax rates.

Your tax rates now vs. later

If you can commit to investing the tax savings from a traditional 401(k) contribution, this debate becomes largely about comparing current versus future tax rates. If your tax rate is low now and you expect it to be higher in retirement, you’ll want to make contributions with after-tax dollars — which you can do with a Roth 401(k). Then you won’t pay taxes at that higher rate when you take qualified distributions in retirement.

This scenario of lower rate now, higher rate later can affect many workers, especially those early in their careers. Your income and standard of living likely will increase over time, so you may want to draw more money in retirement than you’re earning now. There’s also the possibility of across-the-board legislative tax increases; current tax rates are low when put in historical context.

However, if your tax rate is higher now than you expect it to be in retirement, it can make sense to contribute to a traditional pretax 401(k). You’ll then pay taxes at that expected lower rate when taking distributions in retirement. If you’re closer to retirement, you may have a better idea of how your tax rate may change in those years. Many retirees live frugally, resulting in a lower tax burden.

Which is best for you? Compare the Roth 401(k) vs. the 401(k)

Roth 401(k) withdrawal rules

The distribution rules for a Roth 401(k) aren’t as flexible as those for a Roth IRA. Unlike the IRA version, you can’t withdraw contributions from a Roth 401(k) any time you like. The Roth 401(k) has a five-year rule for distributions; you must hold the account for five years before distributions are considered qualified and can be taken tax-free. That rule applies even if you’ve reached 59½, the age at which retirement distributions are typically allowed. That’s something to consider if you’re getting a late start and want to access that money soon.

Then there’s the reverse scenario: You’d rather not access that money at all. Like traditional 401(k)s and traditional IRAs, Roth 401(k)s require you to begin taking distributions at 70½. These are called required minimum distributions. But the Roth 401(k) has an easy way out: You can roll its balance directly into a Roth IRA without a tax burden. The Roth IRA doesn’t require minimum distributions, so you could preserve that money and pass the account to your heirs.

You can contribute to both accounts

Most employers that offer both a Roth 401(k) and a traditional 401(k) will let you switch back and forth between them or even split your contributions. In fact, if your employer offers matching dollars and you contribute to a Roth 401(k), you’ll also have a traditional 401(k) because the matching amount must go into a pretax account.

If you’re switching from a traditional to a Roth, you may want to ease into the bigger tax bite by splitting your contributions at the start. Using both accounts — especially if you’re not eligible for a Roth IRA because of income limits — will enable tax diversification in retirement. You’ll be able to choose whether to pull money from a tax-free or a tax-deferred pot, or a combination of the two, each year. That will let you better manage your taxable income.

Arielle O’Shea is a staff writer at NerdWallet, a personal finance website. Email: aoshea@nerdwallet.com. Twitter: @arioshea.

Updated March 29, 2017.