Many employees are surprised to learn that their employer’s retirement savings plan may offer a Roth option.
You may be participating in a 403(b) or a 401(k) plan, but for this discussion we’ll group them together and refer to them as 401(k) plans moving forward.
While a traditional 401(k) has been the default choice for decades, the Roth 401(k) has become an increasingly valuable tool for building tax-free retirement income. The challenge is knowing when it makes sense and how to use it effectively.
A Roth 401(k) allows you to contribute after-tax dollars to your retirement plan. Unlike traditional 401(k) contributions, which reduce your taxable income today, Roth contributions are included in your current taxable income. In exchange, qualified withdrawals in retirement, including growth and earnings, are generally tax-free. The IRS describes Roth 401(k) contributions as “designated Roth contributions” within an employer-sponsored retirement plan.
Understanding the Trade-Off
The decision comes down to one simple question:
Would you benefit more by receiving the tax break today or receiving a tax-free income later?
For example, suppose you contribute $10,000 to a Roth 401(k) and it grows to $40,000 by retirement. If the distribution qualifies under IRS rules, the entire $40,000 may be withdrawn tax-free. By contrast, accounting for the tax deduction, that same $10,000 may be worth $16,129 if contributed to the traditional 401(k) which means, using the same example, it would grow to $64,516. You have more but everything that is withdrawn from the IRA is subject to taxation.
So, which is better? It depends on your future tax situation, read on.
When the Roth Feature Makes the Most Sense
While every situation is different, several groups often benefit from using the Roth option.
Younger Workers
Employees early in their careers frequently find themselves in relatively low tax brackets compared to what they may experience later in life. Paying taxes today at a lower rate in exchange for decades of tax-free growth can be a powerful strategy.
Employees Expecting Higher Future Income
If you believe your income will rise substantially over your career, today’s tax rates may be lower than the rates you face in the future. Contributing to a Roth 401(k) allows you to lock in today’s tax rate on the dollars you contribute.
Individuals Concerned About Future Tax Rates
No one knows exactly what future tax laws will look like. Some investors choose Roth contributions because they prefer the certainty of paying taxes now rather than taking the risk of potentially higher tax rates decades from today.
Employees Looking for Tax Diversification (less important as current verses future tax rates)
One of the strongest arguments for Roth contributions is flexibility. Having both traditional and Roth retirement accounts creates options later. During retirement, you can often control your tax bracket by deciding which account to pull money from each year.
You Don’t Have to Choose Just One
Many employees mistakenly believe they must choose either traditional or Roth contributions.
In reality, most 401(k) plans allow you to split contributions between both options. For example, you could direct 50% of your contributions to the traditional account and 50% to the Roth account.
This approach creates tax diversification. Part of your retirement savings receives a tax deduction today, while another portion grows tax-free for future use.
For many households, this blended strategy offers the best of both worlds.
Don’t Ignore the Employer Match
A common misconception is that employer matching contributions also go into the Roth portion of the account.
Historically, employer matching contributions were generally deposited into a traditional pre-tax account, even when an employee chose Roth contributions. Regardless of where the match is deposited, contributing enough to receive the full employer match should usually be one of the first priorities in any retirement savings strategy. An employer match can represent an immediate 50% to 100% return on your contribution depending on the plan design.
Simply put: Never leave free money on the table!
How to Get Started
If your employer offers a Roth feature, the process is usually simple:
- Complete or get help completing a financial projection and tax analysis looking at today as well as into the future when you’re likely to use your retirement funds.
*We always recommend you get professional assistance with this step from a qualified fee-only fiduciary financial advisor.
- Log into your retirement plan portal.
- Review your current contribution election.
- Select Roth contributions, traditional contributions, or a combination of both.
- Don’t forget to consider whether your current budget can support the slightly lower take-home pay that comes with Roth contributions.
- Consider setting up automatic annual increases to gradually boost your savings rate over time.
Tip: Many employees find that increasing contributions by just 1% each year allows them to improve retirement readiness without feeling a significant impact on their day-to-day finances.
To Roth or Not to Roth
The Roth 401(k) is not automatically better than the traditional 401(k). The right choice depends on your current tax bracket, expected future income, retirement goals, and overall financial situation.
However, for many workers, the Roth feature represents an opportunity to create a source of tax-free income in retirement while reducing dependence on uncertain future tax laws.
The most important next step is making sure you’re saving consistently, capturing any available employer match, and building a retirement strategy that gives your future self as many options as possible.
Sources and Resources:
Retirement topics – Designated Roth account | Internal Revenue Service
Retirement plans FAQs on designated Roth accounts | Internal Revenue Service
Please note above information or suggestions provided are for general educational purposes only. It is important to seek the guidance of a licensed financial professional before making any investment or financial decisions.
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