The Roth 401k is a great way for people to go tax free! Roth 401k plans have been around for over a decade but are widely misunderstood. Instead of just growing your money for retirement in a tax-deferred 401k, you could grow it in a Roth 401k and never be taxed again! The rules for a Roth 401k can seem complex. This web page will make it easy to understand the pros and cons of a Roth 401k. You will be able to answer many common questions about the Roth 401k. You will learn:
What is a Roth 401k?
A Roth 401k is a way to invest money and grow it without paying taxes. An employer creates a 401k plan and an employee elects to contribute to the Roth 401k on the application form. The employee will choose how much money they want to add to their Roth 401k with every paycheck. Similarly, the employer withholds taxes on the contributions with every paycheck. Roth 401k contributions are eligible for the employer’s contribution, if the employer offers a match or other benefit. Note, however, one confusing quirk in the law. All employer contributions (like a match or Safe Harbor) must go into the traditional 401k and cannot go into the Roth 401k.
Roth 401k limits
Roth 401k contribution limits usually increase every year. In 2024 an employee may put in $23,000 and, if the employee is over the age of 50, they may contribute an additional $7,500.
Note that the Roth 401k has no income limit. Any person who has a Roth 401k plan at work may make a contribution to their Roth 401k, regardless of their income limits. A Roth IRA has a maximum income limit but the Roth 401k has no maximum income limit.
Comparing a Roth 401K to a traditional 401k, IRA and Roth IRA
The biggest difference between the four types of retirement accounts is how and when they are taxed. When you see “Roth,” think “tax-free.” The withdrawal from a Roth 401k or Roth IRA is tax-free. The withdrawal from a traditional IRA and 401k is taxable—but the money going in is either pre-tax or a tax-deduction. A Roth IRA and Roth 401k invests money without taxes and enable tax-free withdrawals. In a traditional IRA or 401k, the contributions are pre-tax, or qualify as a tax-deduction, but the withdrawals are taxed as income.
The second difference is a limit on income. IRA contributions are limited to people who have low incomes or who do not have a retirement plan at work. 401k and Roth 401k allow people to make contributions regardless of the size of their income. Compare this to a IRA and Roth IRA, which prohibit contributions for people with large incomes. A Roth 401k and a traditional 401k does not have a maximum income limit—you can make any amount of money and still contribute to a 401k. This is different from an IRA. If you make more than a certain income, you cannot contribute to a Roth IRA but you may still contribute to a Roth 401k.
A third big difference between these retirement accounts is the size of the contributions. The 401k and Roth 401k have much higher contribution limits than the IRA and the Roth IRA, allowing people to contribute more money every year.
Another major difference is who sets up the retirement plan. A 401k and Roth 401k require an employer to set up a retirement plan. The IRA and Roth IRA can be set up by any individual. IRA contributions can be made by any individual as long as they have earned income. And finally, the two types of plans have different deadlines for contributions. 401k plan contributions must be made within the calendar year and IRA contributions, whether Roth or traditional, can be made all the way up until the tax deadline, usually as late as October of the following year.
In short, the 401k and Roth 401k allow more money to be contributed by higher-income people but require a plan to be set up by the employer. The IRA and Roth IRA may be set up by anyone with earned income. However, the income cannot be higher than the maximum income limits set by the IRS. The Roth IRA and Roth 401k do not have tax deductible contributions but they allow tax free withdrawals. The IRA and the 401k allow pre-tax (or tax-deductible) contributions but force people to pay income taxes when they use the money.
What is a Roth 401k conversion and is it right for me?
With a Roth 401k conversion, an employee takes money from the tax-deferred bucket and puts it into the tax-free bucket. They must pay income tax in the same year of the conversion. A Roth 401k conversion happens within the 401k plan. Not all 401k plan providers allow for in-plan Roth conversions. Check with your plan provider to see if your plan allows for this.
If you have lower income this year than usual, this might be a good year to consider a Roth conversion. People who are in a lower tax bracket this year may include a commissioned salesperson, a franchisee, or someone whose livelihood has been upset by economic events.
Almost always, the best plan is to set aside money outside of the 401k to pay the taxes due on a Roth conversion. Pulling money out of a 401k can be expensive—although there have been some notable exceptions to this rule, it is a good rule to follow! If you are under age 59 ½, the IRS forces you to pay another 10% tax penalty. So young people who want to do a Roth conversion most certainly want to pay the taxes with outside dollars.
How to convert a 401k to Roth IRA
You cannot directly convert a 401k to a Roth IRA. However, you can rollover your 401k to an IRA and then convert from the IRA to a Roth IRA. In the year you make the conversion, you must pay income taxes. The amount of the conversion is added to your taxable income. The Roth conversion is taxed at your marginal income tax rate. A person who is in the 24% tax bracket who converts $50,000 of her IRA to a Roth IRA will pay $12,000 in taxes.
How to convert a 401k to a Roth 401k
If your company allows for in-plan Roth conversions, then you may want to consider it. The money that an employer has put into the 401k on behalf of the employee is always going to be tax-deferred. This includes a match and discretionary profit-sharing contributions. The employee completes a form making an irrevocable decision to pay taxes on the conversion this year, and the dollars are move to the Roth 401k immediately. The Roth 401k money will grow tax-free from that point forward. Distributions will be tax-free. Most companies require a person to leave employer contributions in the tax-deductible accounts for two tax years before allowing a Roth conversion. Many plans also allow older employees to withdraw money annually and roll the proceeds into IRAs and Roth IRAs, without penalty. Check with your company for the rule specific to their 401k plan.
Roth conversions count towards Medicare income limits
Retirees who are receiving—or will receive Medicare in the next two years—will want to be careful about the timing of the Roth conversion. Medicare Part B insurance requires payments. These payments increase when your income increases. A Roth conversion increases income for one year—possibly forcing a person to pay more in Medicare Part B payments than necessary.
Roth 401k and Medicare income limits
Here is how the Medicare Part B income limits work. Medicare looks at the tax return filed two years previous and uses adjusted gross income modified to include things like Roth IRA and municipal bond income. The modified adjusted gross income is run the following income grid. If income is over a certain number, then Medicare increases the cost! Costs are increased for at least 12 months, and quite possibly 24 months because of the two-year lookback. Medicare costs can increase by 240% depending upon income!
Here are the Medicare income limits and additional costs for IRMAA for the year 2024.
Married filing jointly, income in 2024
|Part B/ mo
Single, income in 2024
|Part B/ mo
Married filing separately, income in 2024
|Part B/ mo
For a person considering a Roth conversion, they need to consider both the next higher tax bracket as well as the next higher Medicare Part B bracket. Let’s look at how this may shape the plans for two different couples in tax year 2021.
A married couple with a (modified adjusted gross) income of $100,000 could do a Roth conversion for $76,000 before they hit the next Medicare Part B level, and be forced to pay an extra $712.80 per year for the next two years. They hit the next higher income tax bracket at $172k, and pay an extra 2% on any conversion amounts over $72k.
A married couple with a (modified adjusted gross) income of $175k faces a more complicated situation. The income tax brackets are different from the Medicare Part B brackets. This family has nearly $150k before they hit the next highest income tax bracket, plenty of room for a large Roth conversion. However, they have only $46k of room before they would double their Medicare part B payments from $148.50 to $297 per month! This costs them $1,782 per year for the next two years. They may view that as an unnecessary tax on the Roth conversion, and would rather split the conversion over two years or more instead.
For the most recent Medicare Part B income limits, visit https://www.medicare.gov/your-medicare-costs/part-b-costs
For the most recent tax brackets, visit www.gotaxfreebook.com
Roth 401k withdrawals
A Roth 401k withdrawal may be made after the age of 59 1/2 without taxes or penalty. If a person has held a Roth 401k for less than 5 years, however, there is a 10% penalty tax. It is always best to hold the Roth IRA or Roth 401k for more than five years before making distributions. Complete a form with the custodian, whichever financial institution holds the money, and make sure to check the box “do NOT withhold taxes.” They will liquidate any investments necessary and send the proceeds to you in a check or electronically. A Roth 401k withdrawal is subject to the rules of the employer. If you are younger, then you may not be allowed to make a withdrawal from the plan unless you quick your job. Older employees, the age varies by plan, may be allowed to make Roth 401k withdrawals.
Who should get a Roth 401k?
Employees who have a 401k plan at work should ask their employers about the Roth 401k plan. Not all 401k plans offer the Roth 401k option. The advantages of a Roth 401k are substantial, particularly as time passes. Here are some key people who benefit most from the Roth 401k:
If you are young, or you expect to be working for many more years, then you should consider a Roth 401k
Young people should consider investing in a Roth 401k and/or Roth IRA as soon as possible. The further you are from retirement, the more time your Roth 401k has to grow without taxes! This can add up to a huge difference, as the math shows below. An investment account that must pay taxes every year will be worth less than the Roth 401k, even if they both earn the same rate of return! Here we assume someone invests $6,000 per year, earns 9% per year and either pays 25% in taxes or does not pay those taxes in a Roth 401k.
The difference is astonishing. Over 40 years, is nearly one million dollars in favor of the Roth 401k!
If you will have a pension in retirement, then you should consider Roth 401k
You may have a pension from work. In retirement, the pension income begins and lasts for the duration of your life, and possibly the life of your spouse as well. A pension may keep you in a high tax bracket. Thus, any income you can get in retirement that is tax-free is a great benefit! You will be able to spend money from the Roth 401k or Roth IRA and not have to worry about paying the dreaded income tax. As the following chart shows, taxes eat up a lot of our retirement income. A traditional tax-deferred IRA requires income taxes to be withheld, or paid at the end of the tax year. For a person in the 25% tax bracket, this means you have to pull out 30% more than you plan to spend—with the difference going to the IRS. Ouch!
If you feel you are in a high tax bracket, then you should consider a Roth 401k
The higher your tax bracket, the bigger the advantages of the Roth 401k. As shown in People with pensions benefit from Roth 401k, pulling money from a traditional tax-deferred 401k or IRA is expensive, especially at the higher tax brackets! If you want to spend $10,000 and are in the 24% bracket, you must withdraw $13,200 from your traditional tax-deferred IRA or 401k. If you had saved money in a Roth 401k, your account would decline by only the money you want to spend, $10,000. In the year 2024, the highest tax bracket is 37%. That same $10,000 withdrawal would cost you $15,900 if you made the withdrawal from a traditional tax-deferred IRA!
If you think taxes are going to increase, then you should consider a Roth 401k
If you think taxes are going up, not down, then the money you invest in a Roth 401k is going to be more valuable than the money you invest in a tax-deferred account. As shown in the following chart, future tax rates decrease your spendable money in a tax-deferred IRA.
Unless you invest in a tax free Roth 401k, you are subject to future tax increases. The money inside the Roth 401k is sheltered from future tax increases. The bigger the expected investment returns, the bigger the advantages of a tax-free Roth 401k.
Advantages and disadvantages of a Roth 401k compared to other retirement options
Available since 2006, the Roth 401k plan enables employees to contribute after-tax money into their 401k. The money grows tax-free and, if pulled out after the age of 59 ½, is never taxed again. Money in a Roth 401k is never taxed again, so you don’t have to increase your withdrawal by 59%–that is a huge savings!
Three absolute reasons everyone should consider a Roth 401k
There are three absolute truths about a Roth 401k and Roth IRA that everyone should consider when they are thinking about investing for retirement:
- Tax-deferred is tax-compounded.
- As we age, we lose tax deductions.
- The government is more likely to increase rather than to decrease taxes.
Let’s look at each of these three absolutes.
Tax deferred is tax compounded
Tax deferred is tax compounded. Holding taxes constant, this must be true or you haven’t grown your money. If you have $10,000 in a tax-deferred investment, and your tax rate is 24%, you owe $2,400. If that money grows by 2.5x, so does the tax burden:
A tax-deferred investment account, like a traditional IRA or 401k, gives you a tax deduction or enables you to put pre-income tax money into the account. It grows tax-deferred but then is taxed as income on the way out. If you are going to be in a lower tax bracket in retirement, then tax-deferral might work for you. In that situation, you could pull money out of a tax-deferred account and pay a lower percentage tax. But, as the next two examples show, betting on a lower tax bracket in the future could be an expensive mistake.
As we age, we lose tax deductions
As we age, we lose tax deductions. One of the largest tax deductions we have is the interest we pay on a home mortgage. As we enter retirement, many Americans choose to pay off the home mortgage. Some of them get a reverse mortgage. In either case, the interest is no longer deductible. We lose other tax deductions as we age, including deductions, exemptions and credits associated with raising a family. As we age, we lose tax deductions. As it has been, so it is likely to be. But what if things get worse?
Tax rates are likely to increase
Taxes may increase. Recently, huge amounts of Federal spending helped the country get through the financial crisis, the Covid-19 health crisis and recession. Many people believe the Federal government will use these expenditures as a reason to raise income taxes. We don’t know when, if ever, this will happen. But if it does, then the tax-deferred investment decision becomes more expensive than the tax free Roth decision. Finding ways to go tax free may make both emotional and financial sense. If you think taxes are going to increase then you should consider a Roth 401k
How to invest in a Roth 401k
Check with your employer to see if they offer the Roth 401k plan. This is stated on the paperwork the employer provides you every year. If you see that a Roth is available, then you can invest in the Roth 401k!
Some 401k plans use a website for enrollment, contribution and investment selection. If this is the case, log in to the website and look for the contribution area. Make sure to choose “Roth” if you want to invest in the Roth 401k.
Some 401k plans don’t allow employees to make changes on their website but instead use paper forms. If this is the case for your 401k, then talk with the correct person at your employer, usually your HR manager. Employers sometimes limit how often you may change investments and/or contributions, but usually employers are generous in allowing you to switch from a pre-tax contribution to a Roth contribution.
Importantly, the investments available to you in the Roth 401k are the same as the investments available to you in a traditional 401k. You can invest in US equities, international equities, fixed income and a variety of other options, determined by your employer. Discuss how to invest with your financial planner.
Should I do a Roth 401k in the year 2024?
If you are going to make less money this year than in years past, and years ahead, you may benefit by putting more money into your Roth 401k (or Roth IRA for that matter). Equity markets, by and large, have come out of the Covid-19 crash of March, 2020 in great shape and you may feel confident that the money you have invested in the Roth 401k could do quite nicely over a long future.
As you think about investing in a Roth 401k in 2024, ask yourself these questions:
- How much can I afford to invest?
- Do I expect my income to increase in future years? Stay the same? Decrease?
- Am I optimistic about my investment choices?
- Do I have a financial plan?
- How would having more tax-free retirement income help my financial plan?
- Would I benefit more from a tax-deductible traditional IRA contribution or a pre-tax traditional 401k contribution?
For answers to these questions, you may want to consult a financial planner.
How do I know if my employer offers a Roth 401k?
To find out if your employer provides a Roth 401k, login to the 401k website. If you don’t have a website login, ask your manager for instructions. You may also ask her for the summary plan documents that the employer must provide you annually. In the summary plan document, you will see a section that describes Roth 401k contributions. If it is not there, then you don’t have a Roth 401k option. Ask your employer to add it. Usually it is not an expensive nor complicated benefit for the employer to add to an existing 401k plan. Most plan administrators are comfortable with Roth 401k plans, they are so common today.
What are the tax advantages of a Roth 401k?
The biggest tax advantage of the Roth 401k vs other ways to invest is the tax-free use of the money in retirement.
Three absolute reasons everyone should consider a Roth 401k
You could choose to invest in the same mutual fund in three different types of accounts:
- Roth 401k
- Traditional 401k
- Brokerage, advisory or other taxable account
You’ll earn the same pre-tax rate of return on the investment. Money that grows inside the Roth 401k is never taxed. The withdrawals are tax-free. The amount of money in the account is the same as the amount of money you can spend.
Money that grows in a traditional 401k is tax-deferred. You were able to put money into the account with your paycheck, before you paid income taxes. It’s like receiving a tax-deduction on that contribution—your pre-tax contribution. It grows without taxes but when you want to use the money, then you have to pay income taxes on every withdrawal.
Money that grows in a taxable account, like a brokerage or advisory account, is taxed every year as either long-term or short-term capital gains. Even if the investment earned the same rate of return as the Roth 401k or traditional 401k, the account value will be smaller due to the taxes paid as it goes along. When you want to spend it, you’ll have to pay capital gains tax on the growth: the difference between its current value and the amount you invested.
Is there a Roth 403b?
There is a Roth 403b account. Non-profit organizations can set up retirement plans for their employees that include the tax-free Roth option. Similar to the Roth 401k, the Roth 403b has contribution limits but not income limits. Only employee contributions may go into the Roth 403b plan. Employees may choose to make a Roth conversion on any calendar year.
What happens to inheritors of a Roth 401k?
If you pass away while owning a Roth 401k, the 401k beneficiary documents determine your beneficiary. Almost always your spouse is the primary beneficiary. The only exceptions to this rule are if you are single, your spouse is deceased or your spouse signed a document disclaiming his/her beneficiary rights.
A surviving spouse will receive the 401k and have two choices:
- Combine it with their own Roth IRA and traditional IRA
- Keep a separate inherited Roth IRA and traditional IRA
Note that a person who inherits a Roth 401k very likely inherits two accounts: a traditional tax-deferred account and the tax-free Roth account. Why? Because the employer contributions always go into a tax-deferred investment account even if all of the employee’s contributions go into the Roth. The deceased employee may have completed in-plan Roth conversions, but usually cannot move every dollar into the tax-free Roth. This is explained above: How to convert a 401k to a Roth 401k
It is usually best for a spouse to roll the Roth 401k into his/her Roth IRA. This way she or he can retain control of the distributions. With an inherited Roth IRA, the IRS requires all of the money be distributed out of the account within 10 years—not nice!
Children, grandchildren or other non-spouse beneficiaries need to roll over a Roth 401k into an inherited Roth IRA. They are forced to withdraw all the proceeds within 10 years. Note that they will also have an inherited IRA, and need to pull out the funds within 10 years from that account as well. The inheritors may invest the money any way they see fit. In an inherited Roth IRA, the money will continue to grow tax-free. Similarly, the inherited IRA will not force an income tax bill on the recipient until the withdrawals must be made—again within 10 years. Inherited IRAs and Roth IRAs have more limited benefits than they used to provide, but still give the beneficiary 10 years of tax savings.
The tax information contained in this article is general in nature. Always consult an attorney or tax professional regarding your specific legal or tax situation.