In 2006, when Congress launched the Roth 401(k), it was a kind of hodgepodge of the Roth IRA and traditional 401(k). Ever since, regulators have been ironing out the kinks.

A Roth 401(k) is a type of employer-sponsored retirement plan that is funded with after-tax dollars, unlike a traditional 401(k). It won’t lower your current taxes the way a traditional 401(k) or traditional IRA will, but qualified distributions in retirement come out tax-free.

As with its traditional counterparts, the invested funds can grow tax-free.

“It is a very helpful option and advisors should be encouraging all their plan-sponsor clients to offer it,” said Tom Granger of Security Benefit in Topeka, Kan. “It can be especially beneficial for younger employees, but can also be a great tax diversifier for older employees.”

Roth 401(k) Versus Roth IRA

A Roth 401(k) is similar to a Roth IRA, but with several important differences.

First, just about any kind of investment can be held in a Roth IRA—a mutual fund, ETF, and so forth—but only employer-sponsored savings plans offer Roth 401(k)s.

Second, Roth IRAs are limited to people under a certain income threshold. For 2023, the limit is $153,000 in adjusted gross income for individuals and $228,000 for couples. Roth 401(k)s have no such income cutoffs.

Third, the maximum allowable contribution to a Roth IRA in 2023 is $6,500, or $7,500 if you’re 50 or older. For a Roth 401(k), contributions in 2023 can be up to $22,500 for workers under 50 and $30,000 for those who turn 50 or older by year-end.

In addition, employers can make matching contributions to a Roth 401(k) (they get a tax incentive to do so), which isn’t an option with a Roth IRA.

SECURE Act 2.0 Changes

Up until this year, though, employer contributions had to be paid in pre-tax dollars—that is, to a traditional 401(k) account. Workers had to pay taxes on future distributions from those funds. The SECURE Act 2.0 changed that. Now Roth 401(k) account holders can choose to receive all or some of their employer’s matching contributions in after-tax dollars.

Another change from SECURE Act 2.0 affects the extra money that workers 50 or older can invest, known as “catch-up” contributions.

Starting in 2026, if you earn at least $145,000 annually and choose to make a catch-up contribution, it must be from after-tax dollars. That is, it has to go to a Roth 401(k), not a traditional 401(k).

Clients “will no longer receive a tax deduction for the catch-up contributions,” said Jeff Mattonelli at Van Leeuwen and Co. in Princeton, N.J. “This may discourage some from making them.”

The new regulation is designed to “increase tax revenues from high-income earners,” said Megan Slatter at Crewe Advisors in Salt Lake City. But further guidance is expected, she added.

Backdoor Conversions

Some high earners work around the contribution limits by making what are called “backdoor Roth conversions.” If you’ve reached the contribution limit on a Roth IRA, say, you can convert or rollover additional funds from a traditional IRA or 401(k) to a Roth IRA. You’ll have to pay taxes on the amount, but later, in retirement, qualified withdrawals will be tax-free.

The same principle applies to “mega backdoor Roth 401(k) conversions.” High earners who have maxed out their annual 401(k) contributions can invest up to $43,500 more in after-tax money, if their employer allows—but only to a traditional 401(k). The supplemental amount can then be converted to a Roth 401(k) for a nominal cost.

The tactic has come under fire lately from legislators, but so far it remains perfectly legal.

“The mega backdoor Roth can be a prudent strategy,” said Mallon FitzPatrick, head of wealth planning at Robertson Stephens in New York.

But, he added, “wait a month [after the initial contribution] and then move the funds.” Making the transfer too swiftly could raise red flags with the IRS.

Required Minimum Distributions

Starting next year, required minimum distributions (RMDs) will be waived for Roth 401(k)s, as they are for Roth IRAs. Till then, however, you must take RMDs if you are 73 or older, as with traditional retirement-savings vehicles, or face a penalty.

Another caveat: Roth 401(k) distributions are tax-free only if the account is at least five years old and the account holder is at least 59-and-a-half years old, disabled, or dead. Tax-free withdrawals can continue for heirs, though non-spouse heirs usually must liquidate the account within 10 years.

This brings up some estate-planning possibilities. Heirs might “inherit the entire balance,” noted Laura Cuber at Bartlett Wealth Management in Chicago, and they can “leave the balance in the account until the end of the 10-year period to maximize tax-free growth.”

“For many clients,” added Erin Wood at Carson Group in Omaha, Neb., “leaving a legacy is a higher priority than their personal tax savings.”

Which Type Of 401(K) Is Best

Deciding how much of a paycheck should go to a Roth or a traditional 401(k) can be complex. It is “a unique and personal calculation,” said Isabel Barrow, director of financial planning at Edelman Financial Engines in Alexandria, Va. “If you really feel conflicted, split the difference. Put 50% into the Roth and 50% into the traditional.”

Some advisors turn to financial software. “There are numerous tax packages that can calculate the sweet spot for making Roth versus traditional 401(k) contributions,” said Steve Parrish, St. Augustine, Fla.-based co-director of The American College of Financial Services’s Center for Retirement Income.

Others say the decision depends on where you are in your career. “The Roth 401(k) makes the most sense for employees who expect to have a higher income after retirement than they have at present,” said Stacy Miller, a certified financial planner in Tampa, Fla.

Yet another camp takes the opposite approach. “Clients who are just starting out [should] focus on traditional 401(k)s,” said Stephanie Roberts of Haase Family Advisors at Steward Partners in Albany, N.Y. They need the tax deductions now, she said, even if the deductions are small. Plus, traditional 401(k) contributions lower the client’s taxable income, which can be advantageous when calculating child tax credits or federal student aid, she said.

Only after they earn enough to maximize their annual 401(k) contributions should clients consider putting some or all in a Roth, she said.

But David Brown, associate professor of finance at the University of Arizona, has a different take. “High-income earners face much more tax-rate volatility than low-income earners, and thus benefit more from Roth,” he said.

By paying taxes at current rates, he elaborated, they are protecting themselves against possible future rate hikes on high earners (low earners’ tax rates almost never go up, he said). Current tax rates for high earners are “about as low as they have ever been,” he added.

If you’re still undecided, Prof. Brown suggested a rule of thumb: Add 20 to your age and allocate that percentage to traditional retirement-savings vehicles. The rest should go to Roths.

Diversification And Optionality

With so many technicalities and ever-changing regulations, Roth 401(k)s can seem daunting. “Consider it diversifying [a client’s] tax strategy,” suggested Joel Bailey of Johnson Financial Group in Janesville, Wisc.

Having both Roth and traditional retirement accounts gives clients a degree of flexibility over which to tap when, he said. This can mean “better control over their income taxes in retirement,” which in turn can impact Medicare premiums, he said.