What Is a Roth 401(k) and How Does It Work?

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If you’re a follower of money expert Clark Howard’s investment philosophies and the term “Roth 401(k)” doesn’t already make you smile, it probably will shortly.

Why? Because a Roth 401(k) is right up your alley: It’s an excellent tax-advantaged retirement plan for people who appreciate sacrificing now for a bigger long-term payoff.

In this article, I’ll explain the tax implications of a Roth 401(k), give you the current Roth 401(k) contribution limits and compare Roth 401(k)s to traditional 401(k)s and Roth IRAs.


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What Is a Roth 401(k) and How Does It Work?

A Roth 401(k) is an employer-sponsored retirement plan that combines elements of a traditional 401(k) with elements of a Roth IRA.

With a Roth 401(k), you contribute after-tax dollars. In other words, you’ve already paid taxes on the money you put into your Roth 401(k). So you won’t get an upfront income tax deduction.

But you will get to withdraw every dollar in your Roth 401(k) — contributions and investment earnings — tax-free when you’re 59½ years old (as long as your account is at least five years old).

When you’re deciding whether to contribute to a Roth 401(k) or a traditional 401(k), your key decision is about taxes. Do you want to pay taxes upfront, or do you want to pay taxes when you withdraw in retirement? And which is the smarter strategy?

Clark believes that taxes will increase over time. He thinks we’ll eventually pay for federal budget deficits in the form of tax hikes.

If you agree, paying taxes now and withdrawing every penny tax-free when you’re retired is a winning idea.

“A Roth 401(k) is vastly superior to a traditional 401(k),” Clark says. “With a Roth 401(k), you put in money that’s already been taxed, and it’s never taxed again.”

Most companies now offer Roth and traditional 401(k) plans. If you’re contributing to a Roth 401(k) and your company offers a 401(k) match, however, those matching dollars will be subject to traditional 401(k) rules.

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Roth 401(k) Contribution Limits for 2021

Defined Contribution Plan Limits2021
Maximum employee contributions (under age 50)$19,500
Employee catch-up contributions (age 50+)$6,500
Contribution limit, all sources (under age 50)$58,000*
Contribution limit, all sources (age 50+)$64,500*

*Or 100% of your annual compensation if that’s a lower number.

If you’re younger than 50 years old, you can contribute as much as $19,500 in 2021. You’re eligible to contribute an additional $6,500 in catch-up contributions if you’re 50 or older in 2021.

Here are some things to keep in mind:

  • Contribution limits are cumulative across all plans. Your limits as an employee remain fixed even if you contribute to multiple 401(k) plans or if you split contributions between Roth and traditional 401(k) plans.
  • If you reach your maximum contribution prior to getting your last paycheck of the year, you can lose out on some company match funds.
  • There’s a contribution cap of 100% of your salary. So if you earn less than $19,500, your limit is lower.
  • Some companies allow for post-tax, non-Roth 401(k) contributions. You can convert those contributions to a Roth 401(k) or a Roth IRA. You’ll owe taxes only on your earnings, not your original contributions, if you make that conversion.

Roth 401(k) vs. Traditional 401(k)

The biggest difference between a Roth and traditional 401(k) plan is when you owe taxes.

With a traditional 401(k), you contribute pre-tax dollars. So you get an upfront tax break that lowers your next income tax bill. However, you’ll owe taxes on your contributions and earnings when you take out the money during retirement.

With a Roth 401(k), you contribute post-tax dollars, so you don’t get an upfront tax break. But you won’t owe any taxes when you take money out during retirement.

A Roth 401(k) makes more sense if you:

  • Agree with Clark that the federal government will raise taxes in the future
  • Are maxing out your 401(k) contributions and are able to pay your taxes upfront
  • Are hoping to roll over your 401(k) to a Roth IRA

A traditional 401(k) makes more sense if you:

  • Disagree with Clark and think that taxes won’t increase appreciably in the future
  • Want to prioritize lowering your taxable income for the current year

Roth 401(k) vs. Roth IRA

If you work for a small company, your 401(k) plan could be expensive. Those costs could result in high expense ratios on your investment options and high annual management fees.

If that’s the case, by all means, consider contributing to a Roth IRA, if you’re eligible to do so.

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Otherwise, Clark prefers that you contribute to a Roth 401(k) and that you reach your 401(k) contribution limit before proceeding to contribute to a Roth IRA.

“If you’re with an employer that has a really low-cost 401(k) plan, keep it simple,” Clark says.

“Because then the money automatically comes out of your paycheck. You don’t have to have the best of intentions to put the money in. Automatic is great.”

You can take out the money you contributed to a Roth 401(k) and a Roth IRA at any time. The IRS already has taxed those dollars, so they’re yours. You’ll also be able to withdraw your earnings tax-free once you’re 59½ if your account is at least five years old.

Here are some of the advantages that a Roth 401(k) and a Roth IRA hold over each other.

Roth 401(k) AdvantagesRoth IRA Advantages
• Allows you to get company match• No Required Minimum Distributions
• Much higher contribution limits• More investment options
• Income won't prevent you from contributing• Potentially less expensive
• Stronger legal protection on funds• Less administrative hassle
• Can take out a loan against your account• Option to invest via a robo-advisor

Roth 401(k) Required Minimum Distributions & Early Withdrawal Penalty

You can withdraw Roth 401(k) contributions at any time without paying taxes. After all, the IRS has already taxed those dollars.

However, you can also withdraw Roth 401(k) investment earnings tax-free if you meet two criteria:

  1. You’re at least 59½ years of age.
  2. Your Roth 401(k) account is at least five years old.

There are some exceptions that allow you to avoid the 10% early withdrawal penalty. But the two requirements I listed above apply to most people.

When you’re 72 years old, the IRS requires that you start withdrawing money whether you have a Roth or a traditional 401(k). There are two ways to avoid Required Minimum Distributions (RMDs):

  1. Roll over your Roth 401(k) to a Roth IRA. This is fairly simple because you won’t owe any taxes. (You can rack up a big tax bill rolling a traditional 401(k) into a Roth IRA.) The upside is that you’ll never have to withdraw from your Roth IRA (although your beneficiary could be required to do so). If you roll over your Roth 401(k) to a Roth IRA, you’ll need to wait five years before you’re eligible for tax-free withdrawals on your investment earnings.
  2. Work past your 72nd birthday. If you’re still working, you’re allowed to postpone RMDs from the 401(k) plan at your current company.

Final Thoughts

If your company offers you a 401(k) plan, there’s a good chance you’ll have the option to contribute to a Roth account.

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A Roth 401(k) may be Clark’s favorite type of tax-advantaged retirement account.

Roth 401(k) plans require you to pay taxes upfront, which can be painful. But if Clark’s prediction about future tax rates is correct, contributing to a Roth 401(k) will be an excellent long-term decision.


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