What is a Roth 401k and How Does It Work?

The Roth 401k is an employer sponsored retirement plan. The account has many of the same rules of the Traditional 401k with one key difference. Unlike a Traditional 401k, the contributions you make to a Roth 401k are made with after tax dollars. This allows your dollars to grow tax free in the account, and make tax free withdrawals in retirement.

When you enroll in your company's Roth 401k plan, a percentage of your paycheck is automatically taken out and put in your Roth 401k by your employer. The money inside your Roth 401k is invested in a small selection of mutual funds offered by your plan. You get to select what funds to hold inside of your Roth 401k.

The contributions that you make to your Roth 401k are made with after tax dollars. What does this mean exactly? When you sign up for your employer's Roth 401k plan, you agree to have money taken out of your paycheck automatically each month for your Roth 401k.

Every time you make a contribution to your Roth 401k, the income taxes are taken out of that contribution. Hence, you contribute to a Roth 401k with after tax dollars. Due to this, Roth 401ks offer a tax free growth benefit. The dollars that you place inside of your Roth 401k will buy your chosen investments that your plan offers.  

Over time these investments tend to go up in value. Since these investments are held within a Roth 401k, you will not owe any taxes as you invest. You will also not owe any taxes when you pull the money out in retirement. Since you have already paid income taxes on the dollars you put into the account, you do not have to pay taxes when you pull the money out of the account.

Finally, most employers will match your contributions up to a set amount of your compensation. For example, lets say that your employer offers a Roth 401k plan with a 4% match. If you make $100,000, you could contribute $4,000 to your Roth 401k and your employer would match your contributions with another $4,000 (4% of your compensation).

The way that Roth 401k matches work can vary, so it is important to understand how your specific employer match works. It is also important to understand that some employers have what is called a vesting schedule for matching contributions.

A vesting schedule simply dictates how long it takes before your employer's matching contributions are 100% yours. For example, your employer might have a vesting schedule of 2 years. This means that you would have to work at the company for at least 2 years before your employer's matching contributions are 100% yours.

If you were to leave the company before 2 years, you might only be entitled to a partial amount of your employer's matching contributions or no amount at all. It is important to understand your company 401k vesting schedule as it can sometimes take years before your employer's matching contributions are 100% yours.

Keep in mind that a vesting schedule only relates to your employer's matching contributions. The contributions that you make to your Roth 401k plan yourself are always 100% yours.

A Roth 401k does not make you money itself. It is simply an account that holds investments. It is the investments within a Roth 401k that will make you money. So, you might be asking yourself what you can invest in through a Roth 401k?

It depends upon your company's specific plan, but in general most Roth 401k plans offer a small selection of mutual funds. A mutual fund pools money from many investors and uses that money to buy lots of assets all at once, such as stocks and bonds.

In other words, you do not have to choose individual stocks when you invest through a Roth 401k. You can simply select a few mutual funds from your specific plan that you would like to invest in. Your plan might offer mutual funds that invest in Large Cap US Stocks, Small Cap US Stocks, and International or Emerging Market Stocks.

Some financial experts recommend allocating your Roth 401k investments across several mutual funds offered by your plan. If you need help choosing investments for your Roth 401k, it is a good idea to speak with a financial advisor.

Lets return to the original question - how do you make money with a Roth 401k? It's simple. Once you have chosen several mutual funds to invest in, you simply need to make consistent contributions to the account and wait. As the investments within your Roth 401k grow, you will make money over time.

It should also be noted that your employer match is another way that you can make money with a 401k. Keep in mind that not all employers offer a match. You also need to understand the vesting schedule for your specific plan to make sure that you are able to take 100% of your employer's match.

The Roth 401k has several rules that you must follow when using the account. It is important to understand these rules so that you can use the account properly if you decide to do so.  

Due to the tax benefits that a Roth 401k offers, the amount that you can contribute to the account is limited. For 2024, you can contribute up to $23,000 per year or $30,500 per year if you are 50 or older. These are just the contributions that you are allowed to make. With an employer match, the amount you could invest each year could be higher.

For example, lets say that you are 40 years old and are in the position to make that maximum contribution of $23,000. Lets say that your employer is going to contribute an additional $5,000, which would bring your total contributions for the year to $28,000.

Your combined contributions between yourself and your employer cannot exceed the lesser of 100% your total compensation or $69,000 for 2024.

In general, you are not allowed to pull any of the money out of a Roth 401k until you are at least 59 and a half years old, and have contributed to the account for a minimum of 5 years. If you try to access the money in the account before then, you can incur a 10% penalty on the amount you withdrew, as well as any applicable income taxes.

There are exceptions to this rule, but most financial experts do not recommend pulling money from your Roth 401k until you reach retirement.

Required minimum distributions (RMDs) are the minimum amount you must pull out from a 401k once you reach a certain age. In other words, the IRS forces you to pull money out the account. However, starting in 2024, RMDs do not apply to Roth 401(k)s thanks to the passing of the Secure Act 2.0. This gives you more control over the dollars that you have in the account.

1) Employer match - The biggest benefit of a Roth 401k is arguably your employer's match. If you take advantage of the full match, you can boost the amount you are able to invest by thousands of dollars per year. You have probably heard some people say that a 401k match is "free money".

While we understand the sentiment, remember that your employer might have a vesting schedule which could mean that this "free money" won't actually be yours for years.

2) Tax free growth and withdrawals - Due to the structure of the account, the Roth 401k allows your investments to grow tax free and be withdrawn tax free. If you were to invest through a taxable brokerage account, you could potentially incur taxes on dividends or bond interest during the year you experienced these returns. The Roth 401k shields your investments from these taxes.

3) High contribution limits - When compared to other tax advantaged investing accounts, Roth 401(k)s have high contribution limits. If you are in the position to do so, you can invest large sums of money into a Roth 401k and still get tax benefits.

4) No RMDs - Unlike the Traditional 401k which still has required minimum distribution rules in force, the Roth 401k no longer requires them starting in 2024. This means that you won't ever be forced to pull money out of a Roth 401k. Ultimately, you get more control on the timing of withdrawals from a Roth 401k then you do with a Traditional 401k.

1) Limited investment options -  A Roth 401k does not offer a broad selection of investments. You are stuck with the small selection of investments that your specific plan offers. If you want more control over what you invest in, it is better to invest using a different type of investing account.

2) Lack of accessibility - You are not allowed to access the funds within your Roth 401k until you are at least 59 and a half years old and have contributed to the account for at least 5 years. Now, the point of a Roth 401k is to save for your retirement so some investors don't mind this.

However, if you place all of your available dollars into a Roth 401k, you can run into trouble when you need access to money during the course of your life. This doesn't mean that using a Roth 401k is a bad idea. It simply means it might be better to spread your available dollars across more financial accounts than just a Roth 401k.

3) Lack of control - Since a Roth 401k is an employer sponsored retirement plan, you do not have total control over the account. First, you could be an employee at a company that does not offer a Roth 401k plan. You could also leave a company that does have a Roth 401k plan, for a company that does not.

Secondly, your employer gets to decide what investments the plan holds and how much to match your contributions, if at all. Although a Roth 401k does offer some good benefits, it might not be a good idea to base your entire retirement plan off of it due to the lack of control you have over the account.  

If you are considering a Roth 401k, chances are you have also looked at a Traditional 401k. You are probably wondering which one you should go with. There is an ongoing debate in the financial community. Some individuals advocate heavily for the Roth, the Traditional or a mix of both.

You have probably heard something along these lines. If you expect your taxes to be lower in retirement, you should use a Traditional 401k. The reason? A Traditional 401k allows you to defer paying taxes on the dollars you contribute until retirement. So, you could get a tax break on the dollars you contribute while in a higher tax bracket and then pay taxes when you retire in a lower tax bracket.

On the flipside, if you expect your taxes to be in higher in retirement, it would make more sense to use a Roth 401k. The reason? A Roth 401k has you pay taxes on the dollars that you contribute today, but zero taxes in retirement. If your taxes are higher in the future, it makes more sense to pay taxes now.

This generic advice can be a good starting point to help you pick between the Traditional and Roth 401k. With that being said, it is a bit of an oversimplification. Depending upon your individual circumstances and tax rates, it can make sense to use just the Roth 401k, just the Traditional 401k, a mix of both, or neither at all. Speaking with a licensed financial advisor can help you sort all of this out.

If you do opt to use a Roth 401k, it can also be a good idea to compare it to a Roth IRA. A Roth IRA, or individual retirement account, is a type of investing account that provides the exact same tax benefits of a Roth 401k.

Unlike a Roth 401k that has limited investment options and is only availble through your employer, a Roth IRA allows you to invest in almost any traditional investment and follows you no matter where you go since the plan is held outside of work through an online broker.

Some financial experts recommend opening a Roth IRA after you have contributed enough to your Roth 401k to get your employer's match. A Roth IRA will give you more flexibility over the investments that you have in the account and gives you more control.

The short answer is that it depends. In general, you will probably hear something along these lines. "You should invest enough in your 401k to get your employer's full match." This is probably a good place to start for most people.

The Roth 401k does offer some good benefits and for most every day investors, it can be a good idea to take advantage of them. With that being said, the more money you allocate towards your Roth 401k, the less you will have to allocate to other financial accounts, areas, and investments.

For example, lets say you were in the position to make the maximum contribution of $23,000 to your Roth 401k. If you did make the maximum contribution to your Roth 401k, all of your investments would be tied up in a single account. You would get some benefits by doing this, but you would also be restricted.

Instead, you could contribute enough to your Roth 401k to get your employers full matching contribution and then allocate the remaining dollars to other areas. Lets say that in order to get your employers math, you would need to contribute $8,000 per year.

You would be left with $15,000 of available dollars to invest after investing in your Roth 401k. You could use this money to invest through an IRA, invest in real estate, invest in your own education to increase your earning capacity, and much more.

The point here is that the Roth 401k does offer some benefits that you might want to take advantage of. However, the account does have some drawbacks. The idea here is to take advantage of the benefits that the Roth 401k has, and allocate any remaining dollars you have to other places that don't have the drawbacks of a Roth 401k.

At the end of the day, creating a financial plan that is right for you can be challenging. We always recommend speaking with a financial advisor to help you make financial decisions - including whether or not to use a Roth 401k.

A Roth 401k is an employer sponsored retirement plan. The contributions you make to the account are made with post tax dollars. These dollars then buy investments inside of the account that grow tax free until you retire at which point qualified withdrawals are also tax free.

The Roth 401k has an array of benefits including a potential employer match, tax free growth and withdrawals, high contribution limits, and no RMDs. On the flipside, the account has several drawbacks including a lack of control, accessibility, and investment options.

A Roth 401k might be a good idea, but you may want to contrast it with a Traditional 401k or Roth IRA to ensure it is the best option for you. Keep in mind that the more dollars you allocate to a Roth 401k, the less dollars you will have to allocate to other investing accounts and investments.

Figuring out whether or not to use a Roth 401k, as well as how much to contribute to the account can be quite difficult. Speaking with a financial professional, such as a financial advisor, can help you make a more informed decisison.