You may have heard of 401(k)s and Roth IRAs, but have you ever heard of their love child, the Roth 401(k)?
These accounts are worth looking into, especially if you’re young and just starting out in your career. They remain relatively under the radar: 70% of large companies offer a Roth 401(k) option, but only 11% of Americans with access to a Roth (401)k contribute to one, according to Fidelity. That’s compared to the three quarters of employees who put money into a traditional 401(k).
The Roth 401(k) functions similarly to a traditional 401(k) with one major distinction: money contributed to a traditional 401(k) is considered pre-tax, meaning your contributions lower your taxable income and reduce your current tax bill. The catch? You have to pay taxes on that money when you withdraw it in retirement (if you make a withdrawal from your account before age 59 ½, the IRS imposes a 10% penalty that you’ll have to pay on top of the income taxes owed).
A Roth IRA is the opposite — and this is where the advantage could come in. Your Roth contributions are considered after tax. That is, they’re taxed at the time you make them, so if you believe your income (and your corresponding tax bracket) will only rise, now is the time to put money into a Roth 401(k). You might as well pay less taxes now than more taxes later when you’re in a higher bracket, the thinking goes.
“The really obvious choice for a Roth 401(k) is someone early in their career,” says says Kristi Sullivan, a certified financial planner at Sullivan Financial Planning in Denver, Colo. “A younger person is not making as much as they will in their 30s, 40s or 50s, so their current tax bracket is lower, and they’re not really benefiting that much from a tax-deferred contribution.”
Roth 401(k)s can be especially attractive for young workers who make too much to contribute to a Roth IRA. You can only contribute to a Roth IRA if you are single and make less than $137,000 (or are married and have a combined income of less than $203,000). But Roth 401(k)s have no such income limits. What’s more, they have higher contribution limits than IRAs: in 2019, workers younger than 50 can contribute $19,0000 to their traditional or Roth 401(k), but only $6,000 to their traditional or Roth IRA.
Delayed gratification is the name of the game for Roth 401(k)s: when you go to withdraw the funds in retirement, you get to keep it all; by contrast, when you withdraw money from your traditional 401(k), you’ll pocket less than you pull out because some of your savings belongs to Uncle Sam.
“Retirees love to have a pool of money to withdraw from that doesn’t increase their tax bill,” says Sullivan. There are other pros, too: Roths can also be useful for estate planning, since they allow heirs to inherit a sum of money they don’t have to pay taxes on.
While a Roth 401(k) is usually a no-brainer for young workers, the decision of whether to contribute to one is a bit more nuanced for older workers who might be at their peak earnings, financial advisors say. These higher earners might benefit more from the tax deduction today than in retirement, when they’re likely to be in a lower tax bracket.