What is a Roth 401(k)? This lesser-known retirement account offers unique benefits

When you're reviewing your employer-sponsored retirement options, you might be confused by the plethora of different accounts offered by your company: There's probably a 401(k), a 403(b) or a Roth 401(k).

If you've heard of a 401(k) and a 403(b), but not a Roth 401(k), you're not alone. According to Fidelity, 75% of companies that Fidelity provides retirement services now offer a Roth 401(k) option. However, only 13.6% of those offered a Roth 401(k) actually use one.

Below, Select spoke with Scott Sturgeon, a CFP® and founder of Oread Wealth, about how a Roth 401(k) works and who should use them. 

Most employers offer 401(k) retirement accounts to employees. Named after a section of the IRS tax code, a 401(k) is an employer-sponsored retirement account where individuals invest pretax money, which is deducted directly from their paychecks, and then pay taxes on withdrawals in retirement. A 403(b) is similar to a 401(k), but it's a pre-tax retirement account that's specifically offered by schools and tax-exempt organizations (like NGOs).

A Roth 401(k) is an employer-sponsored after tax retirement account that has features of both a Roth IRA and a 401(k). Like a Roth IRA, contributions to a Roth 401(k) are made with income that's already been taxed, allowing investments to grow and be withdrawn in retirement without being taxed. While traditional 401(k)s reduce your taxable income because contributions are taken directly from your paycheck, Roth 401(k) contributions will not reduce your taxable income. 

Unlike a traditional Roth IRA, there are no income limits for a Roth 401(k), so these accounts are available to everyone (depending on if your employer offers one), regardless of how much money someone earns.

Though Roth IRAs have no required minimum distributions (RMDs) or a minimum amount of money you need to take from your account starting at age 72, Roth 401(k)s do have RMDs. This means that Roth 401(k) account owners must start taking money from their account starting at age 72 (unless they are still working or are not a 5% owner in the company sponsoring the plan). 

The contribution limits for a traditional 401(k) apply to a Roth 401(k). For 2022, the maximum an individual can contribute to their 401(k) accounts is $20,500. In other words, your total contributions across different 401(k) accounts cannot exceed $20,500. 

For people age 50 or older who are closer to retirement, they are eligible to make catch-up contributions of up to $6,500, for a maximum of $27,000 per year.

Some companies will offer to match their employees' Roth 401(k) contributions. With matching contributions for a regular 401(k), the employer matches the employee's contributions, typically between 2% and 5% of someone's pay check. The employee will then pay taxes on those contributions, matching funds and investment earnings in retirement. 

Matching Roth 401(k) contributions work similarly to 401(k) matching contributions. 

"The IRS actually requires employer matching contributions to Roth 401(k)s to be treated like contributions to a traditional 401(k), meaning that those contribution amounts are considered taxable income when you withdraw them later on," says Sturgeon. "So your employer may 'match' your Roth 401(k) contributions, but it's actually being treated as a traditional 401k contribution for tax purposes."

Roth 401(k) employer matching contributions are allocated to a traditional 401(k), so you pay taxes on them later on, according to the IRS. 

When you're choosing between a traditional 401(k) and a Roth 401(k), you should consider whether you want a tax advantage now or later on in life. Sturgeon emphasizes making a long-term plan for saving for retirement in order to reduce your tax bill.

"The idea is [that] when your earnings put you in a lower [tax] bracket, then maybe they will be in the future, the Roth option is typically better," says Sturgeon. "And the reason is that you're just taking advantage of the lower [tax] bracket that you're in, versus potentially being in a higher bracket later on…"

If you anticipate having a lower salary in retirement, a traditional 401(k) may be a better choice.

Additionally, if your employer doesn't offer you a Roth 401(k) option, you might consider opening your own Roth IRA. However, there are income limits on a Roth IRA — if you make more than $144,000 as an individual or more than $204,000 as a married couple filing jointly (in 2022), you're not eligible for a Roth IRA. 

Select ranked Charles Schwab, Fidelity Investments, Ally and Betterment as offering some of the best Roth IRAs based on factors like fees, investment options offered and whether a minimum deposit was required.

A Roth 401(k) can be a good choice for individuals who expect to make more money later on in life. While employees won't pay taxes on the employer's matching contributions until retirement, a Roth 401(k) can still be a useful for people who would prefer to foot the tax bill on their own contributions upfront.

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Correction: A previous version of the article incorrectly stated the income limit for a Roth IRA. The article has been updated to reflect the correct income limit.