Is a Roth 401(k) right for you?

The answer depends on your financial priorities now versus the future.

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Key takeaways

  • The majority of large employers offer a Roth 401(k) retirement plan option, but not many employees choose it.
  • There are pros and cons to choosing a Roth 401(k), and the right answer for you will depend on your own financial circumstances and preferences.
  • Always consult with a financial professional and tax advisor to see how your financial situation might be affected.

In the last few years, it's likely your employer added a Roth 401(k) option to your benefits package. But it's just as likely that you have ignored it so far.

Among the retirement plans that Fidelity provides administrative services for, more than 75% now offer a Roth 401(k) option. But only 13.6% of those eligible currently contribute to a Roth 401(k). Those who have chosen the Roth 401(k) option span all ages and incomes, but it's most popular among participants aged 20 to 34, and those with income from $75,000 to $199,000.1

"There's no right or wrong answer," says Aaron Korthas, senior vice president for workplace investing at Fidelity. "The best option depends on an individual's unique situation."

The low uptake numbers might be chalked up largely to a lack of education and conditioning toward tax-deferred retirement savings.

"Many people just don't understand the option so they haven't chosen it," says Ellen O'Connell, a financial consultant with Fidelity. "Some don't know if their company offers it, some just assume they aren't eligible, and some are just used to getting that lowered income tax now."

What's a Roth 401(k)?

A Roth 401(k) is a kind of hybrid between a Roth IRA and a 401(k), with some rules from each kind of plan. Similar to a Roth IRA, an employee makes post-tax contributions, and any earnings grow potentially tax-free.2 But the contributions are made through regular payroll deductions and have the same limits as a tax-deferred 401(k), which are $20,500 for 2022, with catch-up contributions of $6,500 for those over 50. If you take withdrawals before reaching age 59½ (either because you leave your company or because they allow in-service distributions), your contributions will not be subject to tax, but you must take out a proportional amount of any growth on those dollars, and this may be subject to taxes and early withdrawal penalties if it isn't rolled into another Roth 401(k) account or Roth IRA.

To figure out if a Roth 401(k) may make sense for you, consider these pros and cons:

The pros
Potentially tax-free growth

It can be complicated to quantify the value of potentially tax-free growth versus a current tax deferral. You don't know what your income will be in the future, nor what your tax rate will be.

"If you expect your marginal rate to be at least as high after retirement as it is currently—which would apply to many younger participants who anticipate growing incomes over time—the Roth option could work in your favor over the long term," says Matthew Kenigsberg, vice president of investment and tax solutions at Fidelity. "This also sometimes applies to those who plan to move after retirement from a low-tax state to a high-tax state, say Texas to California."

It could also work out that the dollar amount difference in the taxes you'd pay by the time you get to retirement is very small, meaning the income tax you would pay per year on Roth 401(k) contributions could be roughly equal to what you'd pay eventually on distributions after 59½. Your age and your level of income will influence the bottom line.

Help with RMD concerns

Required minimum distributions (RMDs) apply to Roth 401(k)s in the same way they do to tax-deferred 401(k)s, meaning you'd have to start taking out a specified amount once you turn 72 if you are no longer working. However, once you are retired, you can roll over your plan into a Roth IRA, and then it would no longer be subject to the RMD rules (at least during the lifetime of the original owner), and you could withdraw the money on your own timetable.

Access to tax-free growth at higher income limits

High earners start getting restricted from making full Roth IRA contributions above $125,000 in modified adjusted gross income in 2021 for individuals and $198,000 for married couples filing jointly, and this will be $129,000 for individuals and $204,000 for couples in 2022. But Roth 401(k) plans follow 401(k) plan rules on this issue, which means there are no income restrictions.

You can also make higher contributions in a Roth 401(k) than a Roth IRA. An individual can put $6,000 into a Roth IRA per year, or $7,000 if over 50 in 2021 and 2022. In contrast, you can put $19,500 into a Roth 401(k) for 2021 and $20,500 for 2022, plus $6,500 catch-up if you're over 50 in both years. Or you can mix and match percentages and make some pre-tax contributions and some post-tax contributions. You can adjust throughout the year according to your needs and your plan specifications.

The cons
No tax deferral now

The list of cons may be short for Roth 401(k)s, but missing tax deferral is a big one. When faced with a choice of paying more tax now or later, most people choose to pay later, hence the low participation rates for Roth 401(k)s.

Encouraging people to save for retirement is important, and tax deferral has always been a key driver of savings. The financial justification for this has been that historically, people typically had lower tax rates in retirement than during their working years, and the math generally worked in their favor to have a lower adjusted gross income now and take taxable distributions in retirement.

There are a host of other reasons why a taxpayer might benefit from a lower adjusted gross income today, such as the calculation of child tax credits, financial aid for college, or divorce settlements.

Then there is the impact on take-home pay. "There are many reasons why a person might simply want more cash in their paychecks today," says Kenigsberg.

Since contributions to a Roth 401(k) are with post-tax dollars, the impact gets magnified as salaries grow. But the relative impact to an individual can be very personal, as even a few dollars more in your paycheck can be consequential to your budget, especially when you're just starting out. Choosing more pay today might have other impacts on what you're able to save for and do now, while the rest of your life unfolds.

No matter which option you choose, your future tax rate may be different if your income changes or tax rates change. One big caveat is that the uncertain future can swing the math either way. You could take the tax deferral now thinking that you'll benefit in the future, but it could turn out the other way. "Some people expect to be in a lower tax bracket when they retire, but sometimes they have higher taxable income than they anticipated," says O'Connell.

Bottom line

Figuring out what's right for you might come down to more than just deciding if you can afford to pay the taxes now, and if so, if you want to. Remember, there's no right or wrong answer. You can consider all your options and see what works best for your situation. Also note that you can change your elections if you want to experiment or don't like how things are going, but the timing of the change will depend on the rules of your employer's retirement plan. If you have concerns, you may want to consult with a financial professional or tax advisor to see how your financial situation might be affected.

Next steps to consider

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