A tax-free retirement may be more expensive than it's worth.
Editor's note: This article has been corrected. Some plans do allow contributions and a company match before a loan is paid back. It depends on each plan's rules.
More and more employers are offering workers access to a Roth 401(k). And with the passage of the SECURE 2.0 Act at the end of 2022, you may be able to receive your company match in your Roth account as well.
This account offers the potential for a tax-free retirement. You'll pay taxes on any amount contributed to a Roth 401(k), but you won't pay any capital gains tax or income tax on withdrawals in retirement.
That can make the option appealing for many, but maxing out a Roth 401(k) could be detrimental to your wealth. Here are three reasons to avoid a Roth 401(k) for your retirement savings.
Image source: Getty Images.
1. The fees add up
By far the biggest drawback of investing in a 401(k) -- Roth or traditional -- are the fees. There are administrative fees, service fees, and investment fees. And while they may be manageable, they're not entirely avoidable.
In some cases, the fees may completely nullify the tax advantages of the account. The longer you have to keep your money in the 401(k), the more you should be wary of fees. If you love your job and expect to stay put for decades, you'll need to do a little bit of algebra to see if a Roth 401(k) is really worth it.
In 2023, the average 401(k) participant at a large company paid 0.84% in fees. Someone contributing to their Roth 401(k) and earning an average return of about 9% per year will see the tax advantages of their account completely wiped out after 20 years due to those fees. That assumes they'd pay 15% in capital gains taxes by investing in a regular brokerage account.
If you expect to change jobs more frequently and can roll over your 401(k) into a Roth IRA with no fees, it might be worth it to pay the fees for a few years. But if you expect you'll have to keep the high-fee account around for a long time, you should consider your other options.
2. No easy access
A Roth 401(k) is intended for retirement savings. And any good saver follows Charlie Munger's wisdom: You should never interrupt compounding unnecessarily. But sometimes it is necessary to dip into your savings. Life changes and you need to be able to change with it.
If you're saving exclusively in a Roth 401(k), your options to access that money are limited before the age of 59 1/2. While you can withdraw any amount you contributed to a Roth 401(k) at any time without taxes or penalties, the earnings typically cannot come out penalty-free before you reach age 59 1/2.
Unfortunately, withdrawals from a Roth 401(k) are pro-rated between contributions and earnings. That means if you have $100,000 in your account, but just $75,000 of that is from contributions, a $10,000 withdrawal will consist of $7,500 in contributions and $2,500 in earnings. That $2,500 is subject to income taxes and a 10% penalty tax.
Your plan may offer the option of a 401(k) loan, but the amount of the loan is limited to $50,000 or 50% of the amount in your account, whichever is less. You’ll have to pay yourself interest on the loan amount, and some plans won’t allow you to make additional contributions or receive the company match until you’ve paid back the entire loan.
If you keep your money in a taxable brokerage account, you can access any amount at any time. You'll only owe capital gains taxes on the earnings in your account.
3. You can probably save more money with a traditional 401(k)
While a tax-free retirement might sound nice, it's important to consider the whole picture when it comes to taxes.
You have to pay taxes on Roth contributions in the year you make them. What's more, you'll pay taxes at your marginal tax rate. Your marginal tax rate is the rate people often refer to when they answer the question, "What tax bracket are you in?" For example, an individual making between $62,000 and $115,000 in 2024 would probably say they're in the 22% tax bracket.
Conversely, when you withdraw funds from a traditional 401(k), you'll pay less than your marginal tax rate. That's because you have to fill up all the lower tax brackets first. You get your standard deduction, then the 10% bracket, then the 12% bracket, and finally the 22% bracket. So, even if an individual withdrew $100,000 from a traditional 401(k), they'd only pay an effective tax rate of about 13.8%.
Even if you expect tax rates to climb in the future, you'd have to see a significant rise in tax rates to make the Roth account worthwhile in many cases. You'll want to assess your current tax rates and your expected retirement spending in order to determine whether you can expect to save money on taxes by using a Roth account.
A Roth 401(k) isn't all bad
There are plenty of good reasons to use a Roth 401(k) for your retirement savings. For example, it can be an effective way to earn your company match, and it can provide some simplicity in your savings. But investors should be sure to explore all of their options and determine whether the benefits offered by a Roth 401(k) are worth the costs.
