What Is a Roth 401(k)?

How Does a Roth 401(k) Work?

A Roth 401(k) is an employer-sponsored, tax-advantaged retirement account. Contributions are usually made through automatic payroll deductions using income you've already paid taxes on. As a result, you can withdraw your contributions whenever you like, tax- and penalty-free. That can help reduce your tax bill as a retiree and provide a back-up emergency fund during your working years.

But similar to a Roth IRA, you could end up owing taxes and a 10% penalty if you withdraw your investment earnings too soon. You can avoid this snag by making qualified distributions.

These are withdrawals that happen after the participant has satisfied both of the following conditions:

• Owned the account for five years or longer
• Reached age 59½ (or 55 if they are separating from the 401(k) plan) or has become disabled or passed away

Roth 401(k) Contribution Limits

Annual contribution limits for Roth 401(k)s and traditional 401(k)s are the same. If you have both types of accounts, you can contribute to each but the combined total cannot exceed the annual limit.

Source: IRS

Be aware: Roth 401(k) contributions cannot exceed 100% of your compensation. So, if you are 45 years old and earn $22,000, you cannot contribute more than $22,000 to your Roth 401(k) account even though the limit is $24,500.

Roth vs. Traditional 401(k)

The main difference between a Roth 401(k) and a traditional 401(k) is that traditional 401(k)s are funded with pretax contributions. That means the money you put in is tax deductible, which reduces your taxable income today. The caveat is that you'll be taxed on withdrawals you make in retirement. In some cases, that could push a portion of your income into a higher tax bracket.

Another important distinction is that Roth 401(k)s are not subject to required minimum distributions (RMDs) (unless it's an inherited account). But with a traditional 401(k), RMDs generally begin at age 73.

Learn more: Roth 401(k) vs. 401(k): Which Should I Choose?

How Much Should You Contribute to a Roth 401(k)?

The right amount for you to contribute to a Roth 401(k) will depend on your financial situation and goals. If you're paying down debt, for example, you might contribute just enough to secure an employer match—then put any leftover money toward your debt balances.

Saving early and often is the golden rule of retirement planning. It's generally advised to earmark 15% of your income for retirement in your 20s and 30s, then bump it up to 20% in your 40s and beyond. But don't worry if you're getting a late start. The most important thing is to begin saving, even if it's below these benchmarks. You can review your budget and decide on a monthly contribution that feels good.

Are Roth 401(k)s Eligible for Employer-Matching Contributions?

Yes, but these contributions will likely be funneled into a traditional 401(k) rather than your Roth 401(k). It will then grow tax deferred, but regular 401(k) rules apply to this money. That means:

• You'll be taxed on withdrawals you take in retirement
• Early withdrawals will likely result in a 10% penalty
• RMDs begin at age 73

Pros and Cons of a Roth 401(k)

Roth 401(k)s have unique pros and cons to consider. Understanding how these accounts work can help you decide if it's the right retirement savings vehicle for you.

How to Open a Roth 401(k)

Roth 401(k)s are sponsored by employers. If you're self-employed, you can consider opening a solo Roth 401(k) through an investment brokerage. Otherwise, follow these steps to open a workplace Roth 401(k).

1. Contact your benefits coordinator. First clarify whether a Roth option is available. If it is, ask for enrollment instructions. New hires can likely enroll during the onboarding process. If you're an existing employee, you may have to wait for a specific enrollment period to sign up.
2. Pick a savings target. You might have to contribute a certain amount each paycheck to qualify for an employer match. Review your budget and choose a number that will allow you to live comfortably and still make progress toward other financial goals. Whatever you decide, your contributions will likely be made through automatic payroll deductions.
3. Choose your investments. Decide how to invest your 401(k). Start by reviewing your plan's investment options, then consider your own risk tolerance and goals. Your 401(k) may include a mix of exchange-traded funds (ETFs), mutual funds, index funds and bonds.

Frequently Asked Questions

The Bottom Line

A Roth 401(k) is a workplace retirement account that combines some of the best features of a Roth IRA and traditional 401(k). Your employer might even match some or all of your contributions. Roth 401(k)s also offer tax perks and high contribution limits. But you might prefer a traditional 401(k) that allows for tax-deductible contributions during your working years. The right option for you will depend on your finances and goals.