Is a Roth 401(k) better?

Steve Merrell |

Q: I recently found out that my company offers a Roth option in our 401(k) plan. We can now choose to contribute to the Roth or the traditional 401(k). Some of my coworkers say the Roth is better, but I’m not sure. What do you think?

A: Not every 401(k) plan offers a Roth option, but if yours does, you should take a close look at it. Roth 401(k) plans are similar in many ways to Roth IRAs in that contributions are made with after-tax money and all future gains and withdrawals are tax-free. However, Roth 401(k) plans have benefits that make them more attractive than Roth IRAs.

First, you can put more money into a Roth 401(k) account. For 2020, the contribution limit for a Roth 401(k) is $19,500, or $26,000 if you are over 50. Roth IRA contributions, on the other hand, are limited to $6,000 in 2020, or $7,000 if you are over 50.

Second, there are no income limits on your eligibility to contribute to a Roth 401(k). This is quite different from the rules that govern Roth IRA contributions. For 2020, eligibility to contribute to a Roth IRA starts to phase out for married-filing-jointly taxpayers with modified adjusted gross income greater than $196,000 and is eliminated completely once income exceeds $206,000. For single taxpayers, the income limits are $124,000 and $139,000.

You should be aware that a Roth 401(k) is governed by the same rules as a traditional 401(k). For example, 401(k) account holders are required to take a required minimum distribution from your 401(k) beginning the year you turn 72. This applies to Roth 401(k) account, also. The RMD will be tax-free for a Roth 401(k), but it still may result in pulling more money from the account than you would like.

There are some simple ways to get around the RMD requirement. For example, you can continue working. If you continue working past age 72 and do not own 5 percent or more of your company, you can defer your RMD until you actually retire. If you are already retired, you can simply roll your Roth 401(k) into a Roth IRA.

When dealing with Roth accounts you need to be careful about the five-year rule. The five-year rule says that a Roth account must be in place at least five years before taking withdrawals in order to avoid taxes on the gains you withdraw from the account. Many people do not realize that Roth IRAs and Roth 401(k)s have different clocks. For example, if you have been contributing to a Roth 401(k) for seven years, you are in good shape for withdrawals from the Roth 401(k). However, if you roll that Roth 401(k) into a newly created Roth IRA, the clock starts over again. Therefore, if you move forward with the Roth 401(k) idea, you should also set up and fund a separate Roth IRA. Getting both clocks running now could save you a lot of  grief in the future.

Finally, you need to consider the impact of contributing to a Roth on your current taxable income. The idea of never having to pay taxes on your portfolio’s future gains or distributions is enticing. However, to gain the benefit of the Roth 401(k), you must be willing to live with less take home than you would have by contributing to a traditional 401(k). 
How much take home pay will you need to give up? The answer depends on several factors, but typically it works out to be somewhere between 5 and 10 percent. Another rule of thumb is that your Roth 401(k) contribution should be at least 80 percent of what you would otherwise contribute to a traditional 401(k) plan. If you contribute more, your Roth 401(k) will do better than a traditional 401(k).



Steven C. Merrell  MBA, CFP®, AIF® is a Partner at Monterey Private Wealth, Inc., a Wealth Management Firm in Monterey.   He welcomes questions that you may have concerning investments, taxes, retirement, or estate planning.  Send your questions to: Steve Merrell, 2340 Garden Road Suite 202, Monterey, CA  93940 or email them to