Team Clark is adamant that we will never write content influenced by or paid for by an advertiser. To support our work, we do make money from some links to companies and deals on our site. Learn more about our guarantee here.
If you agree with money expert Clark Howard’s investment philosophy and the term “Roth 401(k)” doesn’t already make you smile, it will shortly.
Why? Because a Roth 401(k) is right up your alley: It’s a 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.
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. Even if you’re contributing to a Roth 401(k), if your company offers a 401(k) match, their matching dollars will go into a traditional 401(k).
Defined Contribution Plan Limits | 2023 |
---|---|
Maximum employee contributions (under age 50) | $22,500 |
Employee catch-up contributions (age 50+) | $7,500 |
Contribution limit, all sources (under age 50) | $66,000* |
Contribution limit, all sources (age 50+) | $73,500* |
*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 $22,500 in 2023. You’re eligible to contribute an additional $7,500 in catch-up contributions if you’re 50 or older in 2023.
Here are some things to keep in mind:
The biggest difference between a Roth and a 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:
A traditional 401(k) makes more sense if you:
If taxes rise significantly in the future, paying your taxes upfront presents a significant advantage to almost everyone.
However, if you’re in some of the largest tax brackets in 2023, the math changes.
In Clark’s opinion, anyone in the 24% federal tax bracket or lower should contribute to a Roth 401(k) instead of a traditional 401(k). For 2023, that’s single filers with taxable income below $182,100 and married couples filing joint returns with taxable income below $364,200.
“You jump from 24% to 32% in terms of tax brackets, the balance starts to become more favorable to doing traditional vs. Roth,” Clark says. “We’re talking about a tiny percentage of the population.”
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 your 401(k) plan charges all-in fees of more than 0.5%, Clark says, contribute enough to your 401(k) to get your full employer match. Then contribute to a Roth IRA if you’re eligible to do so.
Otherwise, Clark prefers 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 investment 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) Advantages | Roth 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 |
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:
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 73 years old, the IRS requires that you start withdrawing money if you have a traditional 401(k). (Roth 401(k) account holders no longer are subject to these forced withdrawals.) There are two ways to avoid Required Minimum Distributions (RMDs):
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.
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.
This post was last modified on July 18, 2023 8:55 am
Being invited to a destination wedding can be a celebratory affair for all involved, but…
Are you looking for a good cash back credit card with no annual fee? The…
A 401(k) plan is one of the best benefits you can receive as a full-time…
A recent warning from the federal authorities cautions drivers to be on the lookout for…
Even if you're a travel veteran, the thought of sprinting through the airport with your…
Vanguard, one of Team Clark's favorite brokerage firms, recently announced to its customers several "junk…