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Should You Consider a Roth 401(k)?

Retirement Savings: Benefits of Roth 401(k)

Many companies now offer employer-sponsored Roth 401(k) retirement accounts alongside traditional 401(k) plans, giving employees another way to save for retirement. What's the difference between the two accounts? And should you consider opening a Roth 401(k)?

Here we’ll take a look at how Roth 401(k) plans stack up against their traditional counterparts and what to consider before contributing to one.

Roth 401(k) vs. traditional 401(k)

Most people are familiar with how traditional 401(k) retirement plans work: Employees contribute pre-tax dollars, choose from a variety of investment options, and then contributions and earnings grow tax-deferred until they are withdrawn and taxed, usually in retirement.

With a Roth 401(k), the main difference is when the taxman takes his cut. You make Roth 401(k) contributions with money that has already been taxed (just as you would with a Roth individual retirement account, or IRA). Your earnings then grow tax-free, and you pay no taxes when you start taking withdrawals in retirement.1

Another difference is that if you withdraw money from a traditional 401(k) plan before you turn 59½, you pay taxes and potentially a 10% penalty on the entire withdraw.2 With a Roth 401(k), you can withdraw your contributions (cost basis) tax- and penalty-free, but if the distribution is not a “qualified distribution,” the earnings will be taxable and potentially subject to the 10% penalty.

One similarity between Roth and traditional 401(k)s is that you must start taking required minimum distributions (RMDs) once you reach age 72 (70½ if you turned 70½ in 2019 or earlier) or face a penalty. However, you can avoid this requirement when you retire by rolling your Roth 401(k) into a Roth IRA—which has no RMDs—so your assets can continue to grow tax-free and they can be passed along to your heirs.

“This flexibility is a significant difference between Roth and traditional 401(k)s or IRAs,” says Rob Williams, CFP® and vice president of financial planning at the Schwab Center for Financial Research. 

You can also still get matching contributions from your employer. One thing to note here is that the annual contribution limit would apply across both accounts. For example, you wouldn’t be able to contribute $19,500 to both types of 401(k) in 2020. You would have to divide that amount, say by putting $9,750 in each account.

Finally, as with a traditional 401(k), a Roth 401(k) has a far higher contribution limit than that available for a Roth IRA.

  • In 2020, you can contribute up to $19,500 a year to a 401(k) (or $26,000 if you're 50 or older ). IRA contributions are capped at $6,000 per year (or $7,000 if you’re 50 or older).
  • Also, there are no income limits for Roth 401(k) contributions. In 2020, you can contribute to a Roth IRA only if your modified adjusted gross income is less than $139,000 (single) or $206,000 (married filing jointly).


Which account is right for you?

Traditional 401(k) Roth 401(k)
You make pre-tax contributions and pay tax on withdrawals in retirement You make after-tax contributions and don’t pay tax on withdrawals in retirement

Contribution limits for 2019:

$19,500, or $26,000 if you’re age 50 or older

Contribution limits for 2019:

$19,500, or $26,000 if you’re age 50 or older
You must take RMDs starting at age 72 (70½ if you turned 70½ in 2019 or earlier)  You must take RMDs starting at age 72 (70½ if you turned 70½ in 2019 or earlier)  However, you can roll over funds to a Roth IRA to avoid RMDs
Heirs are subject to RMDs and taxed on distributions Heirs are subject to RMDs but not taxed on distributions
Employer’s matching funds are added directly to your 401(k) account Employer’s matching funds are deposited into a separate tax-deferred account

Source: Schwab Center for Financial Research.


When a Roth 401(k) can make sense

Taxes are a key consideration when it comes to deciding on a Roth 401(k).

If you are young, currently in a low tax bracket and expect to be in a higher tax bracket when you retire, then a Roth 401(k) could be a better deal than a traditional 401(k). Think of it this way: With a Roth 401(k) you can get your tax obligation out of the way when your tax rate is low, and then enjoy the tax-free earnings later in life.

The same argument can apply to mid-career workers, as well, especially those concerned about the prospects for higher tax rates in the future. After all, current tax rates are fairly low by historical standards. The top rate for married couples filing jointly is 37% in 2020, but it was 70% as recently as 1981 and an eye-watering 91% back in 1963.4

“On the flip side, it may make less sense to contribute to a Roth 401(k) if you think your tax bracket will be lower in retirement than it is now,” Rob says.

And high earners who expect to maintain their income and spending standards into retirement could also consider using Roth 401(k)s to simplify their taxes by paying them up front while they’re still working. Doing so would also limit the tax impacts of having to take RMDs, which are treated as taxable income. 

Covering your bases through tax diversification

If you’re not sure where your tax rate, income and spending will be in retirement, one strategy would be to contribute to both a Roth 401(k) and a traditional 401(k). The combination will provide you with both taxable and tax-free withdrawal options. As a retired individual or married couple with both Roth 401(k) and traditional 401(k) accounts, you could determine which account to tap when based on your tax situation.

“You can’t really know what future tax rates will look like, so building in the flexibility to use multiple accounts to manage taxes is important and helpful,” says Rob. 

For example, you could take RMDs from your traditional account and withdraw what you needed beyond that amount from the Roth account, tax free. That would mean you could withdraw a large chunk of money from a Roth 401(k) one year—say, to pay for a dream vacation—without having to worry about taking a big tax hit.

Besides having the added flexibility of being able to manage your marginal income tax bracket, reducing your taxable income in retirement may be advantageous for a number of reasons, including lowering the amount you pay in Medicare premiums, paring down the tax rate on your Social Security benefits, and maximizing the availability of other income-based deductions.

1 Individuals must have the Roth account established for 5 years and be over the age of 59½ for tax-free withdrawals.
2 Individuals separating from service on or after the year that they turn 55 are exempt from the 10% penalty.
3 To be a “qualified distribution” the following rules must be met: 1) After you have reached age 59.5 (or died or become disabled), and 2) At least 5 years after the first day of the calendar year in which you first made a Roth contribution to the retirement plan.
4 Source: The Tax Foundation, 3/22/2017.

What you can do next

Important Disclosures

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

This information is not intended to be a substitute for specific individualized tax, legal or investment planning advice. Where specific advice is necessary or appropriate, Schwab recommends consultation with a qualified tax advisor, CPA, financial planner or investment manager.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

A rollover of retirement plan assets to an IRA is not your only option. Carefully consider all of your available options which may include but not be limited to keeping your assets in your former employer's plan; rolling over assets to a new employer's plan; or taking a cash distribution (taxes and possible withdrawal penalties may apply).

Prior to a decision, be sure to understand the benefits and limitations of your available options and consider factors such as differences in investment related expenses, plan or account fees, available investment options, distribution options, legal and creditor protections, the availability of loan provisions, tax treatment, and other concerns specific to your individual circumstances.

Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.

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