Best Strategies for Your Roth 401(k)

Reviewed by Margaret JamesFact checked by Jiwon MaReviewed by Margaret JamesFact checked by Jiwon Ma

More companies today are offering a Roth 401(k) option as part of their retirement plans. If your employer is among them, and you’ve decided to go the Roth route, here are five ways to maximize your returns.

Key Takeaways

• You can fund both a Roth 401(k) and a Roth IRA. Each has its own advantages.
• 401(k)s have higher contribution limits than IRAs.
• With an IRA, you have greater flexibility in choosing your own broker and a wider choice of investments.
• Contributions into Roth retirement accounts do not give you an upfront tax break, but qualified withdrawals (as long as it’s been five years since you first contributed to the account) are tax-free. Traditional 401(k)s and traditional IRAs, on the other hand, work differently.

1. Start Early

As with many investments, the sooner you start, the better your eventual returns are likely to be. An added advantage of opening a Roth 401(k) as early as possible in your career is that, unlike a traditional 401(k) or traditional individual retirement account (IRA), you fund it with after-tax income and pay taxes on that money today, rather than later in life when you may be in a higher marginal tax bracket.

Your tax rate is generally lowest when you’re young and early in your career. Once you’re further along and have received some promotions and raises, your tax rate will probably be higher. While a traditional 401(k) or traditional IRA lowers your taxable income in the year you make contributions, this tax benefit is typically better suited for investors who are in higher tax brackets.

2. Hedge Your Bets

Nobody knows what will happen in the economy by the time your retirement date arrives. While it might not be something you want to think about, an adverse event, such as a job loss, could put you in a lower tax bracket than you are in right now. For these reasons, some financial advisers suggest clients hedge their bets by splitting their money between a Roth 401(k) and a traditional 401(k).

In the investment world, a hedge is like an insurance policy. It removes a certain amount of risk. In this case, if you split your retirement funds between a traditional 401(k) and a Roth 401(k), you would pay half the taxes now, and half when you retire, when rates could be either higher or lower.

If your employer matches any or all of your Roth 401(k) contributions, those funds will be deposited in a separate, pre-tax account, so there’s a chance you’ll end up with both Roth and traditional 401(k)s anyway.

When it comes time to retire and withdraw contributions, this also allows you greater latitude in withdrawing funds. You may have to withdraw a certain amount from your traditional retirement accounts to avoid a hefty tax liability. The remainder of your living expenses can be funded from your Roth accounts.

Important

At minimum, try to put enough money into your company 401(k) to make the most of your employer’s match. It’s free money.

3. Know Your Limits

If you’re under age 50, you can contribute an annual maximum of $23,000 to your 401(k) account for 2024. (It was $22,500 in 2023.) If you’re 50 or older, you’re allowed an additional catch-up contribution of up to $7,500 in 2023 and in 2024.

You can split your contributions between a Roth and a traditional 401(k), but your total contributions can’t exceed the maximum amount.

4. Fund a Roth IRA Too

The Roth IRA has some benefits that are worth considering. With a Roth IRA, you may have more investment options than you have with a Roth 401(k). In addition, the rules for withdrawing funds are different. With a Roth IRA, you are generally able to withdraw your contributions (but not their earnings) at any time and pay zero taxes or penalties. That’s not the point of a retirement account, of course, but knowing that you could take out some money in an emergency might be reassuring.

Income Limits

Both Roth IRAs and Roth 401(k)s take after-tax contributions. You can contribute to both a Roth 401(k) and a separate Roth IRA, as long as you don’t exceed the income limits for the latter.

For 2024, the IRS’s Roth IRA income eligibility and phase-out ranges are as follows:

• $146,000 to $161,000 for singles and heads of household
• $230,000 to $240,000 to married couples filing jointly
• $0 to $10,000 for married couples filing separately

For 2023, the IRS’s Roth IRA income eligibility and phase-out ranges were as follows:

• $138,000 to $153,000 for singles and heads of household
• $218,000 to $228,000 to married couples filing jointly
• $0 to $10,000 for married couples filing separately

Investors below the minimum threshold can contribute 100% of the IRA contribution limit. Income earners above the threshold are not eligible to contribute. Income within the phase-out range is subject to a percentage contribution restriction.

Contribution Limits

Roth IRAs are subject to the IRA contribution limit, while Roth 401(k)s are subject to the 401(k) contribution limit. The IRA contribution limit is much lower than the 401(k) limit.

In 2024, the contribution limit for any type of IRA, is $7,000 if you are under age 50. (In 2023, it was $6,500.) Individuals age 50 or older can contribute up to an additional $1,000 in 2024. (In 2023, it was also $1,000.) In contrast, the contribution limit for a 401(k) in 2024, as mentioned above, is $23,000 if you are under age 50. (In 2023, it was $22,500.) If you’re 50 or older, you can contribute up to an additional $7,500 in 2024. (In 2023, it was also $7,500.)

Important

Review your account periodically to check how your investments are performing and whether your asset allocation is still on track.

5. Don’t Forget About It

Employer-sponsored retirement plans are easy to neglect. Many people just let their account statements pile up unopened. As the years go by, they may have little knowledge of their account balances or how their various investments are performing. They may not even remember exactly what they’re invested in.

A retirement account isn’t meant for constant changes. However, it’s wise to evaluate the investments you chose at least once a year. If they’re constantly underperforming, it might be time for a change. Or, your asset allocation may have gotten out of whack, with too much money in one category (such as stocks) and too little in another (such as bonds).

If you’re not well-versed in the investment world, it’s probably best to get the advice of a financial professional, such as a fee-only financial planner.

How Does a Roth 401(k) Work?

When you contribute to a Roth 401(k), the income you pay into the account has already been taxed.

This means when you retire and it’s time to make withdrawals, you won’t pay taxes on your investment or on any gains you’ve made, as long as you’re over age 59 ½ and you’ve had the account for at least five years.

Is a Roth 401(k) Better Than a Traditional 401(k)?

Both types of accounts can be excellent ways to save for retirement, especially if your employer is offering a match.

A traditional 401(k) has immediate tax advantages. The contributions you make reduce your taxable income in the year you make them, so you’re paying less in taxes while you’re working.

A Roth 401(k) makes a bigger immediate hit on your income now. But down the road, as long as you’ve had the account for five years, you’ll owe no taxes on your account, not even on the profits your money earned.

What Is the Downside of a Roth 401(k)?

The main disadvantage to any Roth retirement account is there is no immediate tax benefit. It leaves you with a little less income to spend each month.

In addition, distributions from a Roth 401(k) are often less flexible than Roth IRA distributions.

The Bottom Line

Investors have many tools at their disposal to save for retirement. One of those items in their arsenal is the Roth 401(k).

Though it doesn’t provide immediate tax benefits, earnings can grow tax-free. Your employer may match contributions, though those contributions will be put into a traditional 401(k). If you decide a Roth 401(k) is right for you, consider the income limits and contribution thresholds.

Read the original article on Investopedia.