Roth 401(k): An investment option that can help you create a tax-free income stream in retirement

Roth 401(k): An investment option that can help you create a tax-free income stream in retirement

A 401(k) is a type of employer-sponsored retirement plan that allows you to invest your income and grow it over time. There are two types: the traditional 401(k), which is funded with pre-tax earnings, and the Roth 401(k).

You fund Roth 401(k)s with money you’ve already paid income taxes on. This allows you to withdraw funds from the account tax-free in retirement. 

“A Roth 401(k) is an excellent option for anyone who wants to create a tax-free retirement income source,” says Matthew Stratman, lead financial advisor at South Bay Planning Group.

How does a Roth 401(k) work? 

The Roth 401(k) has been around since 2006 and is designed as a hybrid of the traditional 401(k) and the Roth IRA.

Like a traditional 401(k), a Roth 401(k) is employer sponsored. An employer establishes the plan, chooses the investment options, and then offers the plan to individual workers. The main difference between the two types is how the tax advantages work. A Roth 401(k) can be beneficial if you expect your tax bracket to be higher in retirement.

There are exceptions, of course. In order to withdraw funds tax-free, you’ll need to be at least 59 ½, and you must have had the account for five years or more. This rule applies to all Roth accounts.  

There are also rules regarding contributions. For 2021, you can contribute as much as $19,500 per year, plus an additional $6,500 if you’re 50 or older.

What are the benefits of a Roth 401(k)? 

The big benefit of a Roth 401(k) is that it allows you to take tax-free withdrawals in retirement. If tax rates rise or your tax bracket is higher by that time, this could mean significant savings in the long run.

“Many individuals with pensions, a sizable investment portfolio, or a side job may find that their income continues to rise even after they retire from their 9-to-5,” Stratman says. “Taxes may soon be rising, so a Roth could be a great way to take advantage of today’s low tax rates and withdraw in the future tax-free.”

Another advantage is that your money grows tax-free, too. Since a Roth 401(k) is funded with post-tax dollars, you won’t pay any taxes upon withdrawal — even on the money earned through investing. 

“It can be significant — especially if you factor in the compounded growth that’s likely to have happened,” says Maggie Gomez, a certified financial planner and founder of Money with Maggie. “In a sense, all of that growth is free money that’s not taxed.”

Roth 401(k) vs. traditional 401(k) 

Since the major difference between a Roth 401(k) and a traditional 401(k) is when the money is taxed, the main consideration when choosing between the two is your current tax bracket and where you expect it to be down the line. With the Roth 401(k), you pay taxes on the money before putting it in the account. With a traditional 401(k), your contributions reduce your taxable income for that year, and you pay taxes on withdrawals later in life. 

“Early in your career, your salary is likely lower, meaning your tax rate is also lower,” says Phil Weiss, principal at Apprise Wealth Management. “As you work longer and your income grows, your tax rate will likely increase. That makes the tax deferral that comes with contributing to a traditional 401k potentially more valuable.”

Here’s how the two retirement accounts measure up:

The financial takeaway

Roth 401(k)s come with a major tax advantage, particularly if you expect your tax bracket to increase by retirement. They also allow your money to grow tax-free. 

If your employer offers a Roth 401(k) option, think carefully about your career trajectory and financial goals before deciding whether to open one. In some cases, you may be able to have both a Roth 401(k) and a traditional 401(k) simultaneously. Be sure to ask your tax advisor or a financial planner if you need more personalized guidance.

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