Have you heard of a Roth 401(k)?

You’re probably familiar with traditional 401(k) plans, and we hope you know about Roth IRAs as well. (If not, check out these 5 things you should know about Roth IRAs). But did you know there’s also a Roth 401(k)?

Basically, a Roth 401(k) is a 401(k) account to which you can contribute either pre-tax dollars, like a regular 401(k), or post-tax dollars, like a Roth IRA. All your contributions grow tax-free, but your pre-tax contributions will be taxable when you withdraw them in retirement and your post-tax contributions will be tax free.

It’s technically called a “designated Roth” account, and it’s an option your employer can add to your company 401(k) plan. The same provision for a Roth option can also be added to other kinds of qualified retirement plans, such as 403(b) or 457 plans.

If you own a business and sponsor a qualified retirement plan for yourself and your employees, you may want to consider adding a Roth option. And if you’re self-employed and have no employees except your spouse, you could establish a solo 401(k) plan that allows Roth contributions.

So why would you need a Roth 401(k) if you already have a Roth IRA?

Here are four ways that Roth 401(k)s and Roth IRAs are different:

  1. Income restrictions: If you have a high income, you may not be allowed to contribute to a Roth IRA. (It’s complicated, but if you’re single and make more than $122,000 or married with a joint income above $193,000 you’ll face at least some restrictions). On the other hand, there is no income restriction for a Roth 401(k) account.
  2. Contribution limit: You’re allowed to contribute much more per year to a Roth 401(k) than to a Roth IRA. So if you have more money to save for retirement and you want it to be tax-free when you withdraw it after you retire, a Roth 401(k) can help you get there faster than a Roth IRA.IRA and 401(k) contributions are both limited to a total maximum over all accounts of that type. For IRAs, including Roth accounts, that total is $5,500 for 2018 and $6,000 for 2019, with an additional $1,000 allowed if you’re over 50. For 401(k)s, including Roth 401(k)s, the contribution limit for 2018 is $18,500 with an additional $6,000 if you’re over 50. For 2019 the limit is $19,000 with an additional $6,000 if you’re over 50.
  3. Distribution restrictions: This is one area in which a Roth IRA has more flexibility than its 401(k) counterpart. With a Roth IRA, you can withdraw your contributions (but not the investment earnings on those contributions) for any reason with no penalty. And after you’ve owned your Roth IRA for at least five years, you can withdraw money (including investment earnings) from it before you reach retirement age for several reasons, such as buying a first home. A Roth 401(k) does not have the same flexibility, although your employer’s plan may allow you to borrow from your Roth 401(k) as you could from a regular 401(k) account.
  4. Required distributions: You are not required to withdraw money from a Roth IRA at any point in your life. Your money can grow tax-free for your entire lifetime. Your beneficiaries will have to take required minimum distributions (RMDs) from a Roth IRA they inherit from you, but that money will almost always be tax and penalty free. You are required to take RMDs from Roth 401(k) accounts, but you can avoid those by rolling over your Roth 401(k) into a Roth IRA after you retire.

Roth accounts are one of the few options available to invest your money and have it grow truly tax free. You’ll have already paid tax on the money you contribute to your Roth account, and that money plus all the dividends and investment growth that results from it will never be taxed again. Just be sure to follow the laws for your Roth accounts to make sure you don’t incur a penalty.

Here are a few benefits of Roth accounts — 401(k)s and IRAs — over other types of retirement accounts:

  • Withdrawals from Roth accounts are not included in the formula that determines how much of your Social Security benefits will be taxed.
  •  Similarly, withdrawals from your Roth accounts will not be counted when your Medicare Part B premiums are calculated.
  • Roth accounts will transfer tax-free to your beneficiaries after your death.

Something to be aware of: If your employer offers a 401(k) match and you choose to contribute money to your Roth 401(k) account, the match will still be applied but it will go into a regular 401(k) account and therefore be taxable when you withdraw it.

Depending on several factors such as your income, your retirement savings goals, and how much cash you can invest for your retirement, a Roth 401(k) could offer you advantages over a Roth IRA or a traditional 401(k).

For many people, there are benefits to having a mix of taxable and tax-free retirement savings. Your financial advisor can help you figure out the right balance, and if a Roth 401(k) is a good fit for you.

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