My company 401(k) plan offers a Roth option. Should I use it?

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Choosing an employer-sponsored retirement plan.

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Congrats—you’re saving for retirement! You’ve already decided you’d like to invest in a Roth retirement plan so you can set aside after-tax money now and enjoy tax-free withdrawals later. But should you set up your own Roth IRA or invest in your employer’s Roth 401(k)?

If your workplace offers it, a Roth 401(k) offers a couple advantages over Roth IRAs—no income limits, for one.

A Roth 401(k) is just a regular 401(k) plan with a Roth component built in—and a growing number of employers are providing this option, according to the trade group Plan Sponsor Council of America. In 2020, 86% of workplace plans—including 401(k), 403(b), and governmental 457(b) accounts—offered a Roth savings option. That’s a 37% increase over the previous decade.

How does a Roth 401(k) work? Just like a Roth IRA, you can opt to save after-tax money in the Roth portion of your 401(k). Some employers may give you the option of saving in the traditional, tax-deferred part of your account, as well as the Roth portion. Note that if you’re self-employed, you can open a solo Roth 401(k).

Remember: With a traditional 401(k), your contributions are made before taxes are taken out of your paycheck, so you get a tax break up front. But when you withdraw those funds in retirement, you pay taxes at your current ordinary income rate.

With a Roth 401(k), you pay taxes on your full paycheck and your contributions come out after tax. In other words, there’s no tax break up front. But, when you withdraw the money in retirement, you’re exempt from taxes. No taxes on the money you contributed, nor on the compounded growth of that money.

The best part about the Roth 401(k) option is that it eliminates two hurdles that have prevented some people from considering Roth IRAs:

Note: Although you can withdraw your principal (the amount you contributed) at any time—tax and penalty free—from a Roth IRA, the same is not true of a Roth 401(k). These accounts are structured like traditional 401(k)s, in that early withdrawals are subject to a 10% penalty—except under certain circumstances (e.g., hardship withdrawals).

To contrast the different aspects of these plans, it may help to see them side by side:

An important aspect of both Roth 401(k)s and Roth IRAs is the 5-year rule, noted in the chart above. This IRS guideline states that you must hold the account for five years, and you must be at least 59 1/2 to withdraw your earnings tax and penalty free—whichever is later. So, if you’re 59 1/2 but you’ve only been contributing to your Roth 401(k) for four consecutive tax years, you need to wait one more year if you want to withdraw principal or earnings tax and penalty free.

That said, you can withdraw principal and earnings penalty free if you are (or become) permanently disabled—or a beneficiary can, after your death. But under ordinary circumstances, if you haven’t held the account for at least five years since you made your first contribution, and you’re not at least 59 1/2, you could owe taxes and a 10% penalty on any withdrawals. It’s also important to note that the IRS rules and your plan rules may differ, so be sure to check with your plan administrator if your withdrawals might be considered early.

To understand this part, it helps to remember that a Roth 401(k) is a component or segment of your existing 401(k) plan. While the money you contribute to a Roth 401(k) is after tax, any employer contributions would be held in the tax-deferred part of the 401(k) account.

That means when you withdraw money in retirement, you wouldn’t pay taxes on your own savings—but you would owe tax on your employer contributions, plus any earnings.

It also means that if you leave your job and wish to roll over the account into a new employer plan or an IRA, you should make sure the proceeds are segregated by Roth and tax-deferred status. Learn more about 401(k) rollovers.

If you’re certain you want to save for retirement—and don’t need to pull your principal out—an employer-sponsored Roth 401(k) plan has some benefits over a Roth IRA. And setting up a solo Roth 401(k) is an option if you’re self-employed.

It’s true that contributing to a Roth 401(k) will have an impact on your tax bill now, because you’d be forgoing some or all of the tax-deductible contributions you’d normally make to a traditional, tax-deferred 401(k). But you’ll reap the benefits by having tax-free income in retirement.

In other words, which adage do you prefer: “A bird in the hand is worth two in the bush,” or “Good things come to those who wait”?