The Roth 401(k) has become an increasingly popular retirement savings option offered by employers. With the SECURE 2.0 Act updates, some companies even allow matching contributions to be directed into Roth accounts. The main appeal? The promise of tax-free income in retirement. You contribute money you’ve already paid taxes on, and qualified withdrawals in retirement are free from both income tax and capital gains tax.
While the idea of tax-free retirement income is attractive, focusing solely on maximizing a Roth 401(k) can actually hinder your long-term wealth accumulation. Here are three significant reasons why a Roth 401(k) might not be the best strategy for your retirement savings.
1. Fees Can Erode the Tax Advantages
One of the most significant drawbacks of any 401(k), whether Roth or traditional, is the presence of fees. These can include administrative fees, service fees, and investment fees. While individual fees may seem small, they can accumulate over time and substantially impact your returns.
In some cases, the cumulative effect of these fees can completely negate the tax benefits that a Roth 401(k) offers. The longer your money remains invested within the 401(k) structure, the more critical it is to carefully consider the impact of fees. If you anticipate staying with your current employer for many years, it’s essential to evaluate whether the Roth 401(k)’s tax advantages truly outweigh the cost of these ongoing fees.
Data from 2023 indicates that the average 401(k) participant in a large company paid around 0.84% in fees. For someone consistently contributing to their Roth 401(k) and achieving an average annual investment return of approximately 9%, these fees could entirely eliminate the tax advantages after about 20 years. This calculation assumes a 15% capital gains tax rate if the same investments were held in a standard brokerage account.
If you expect to change jobs relatively frequently and have the option to roll over your 401(k) into a Roth IRA with potentially lower or no fees, enduring 401(k) fees for a shorter period might be acceptable. However, if you foresee your retirement savings remaining in a high-fee 401(k) for the long haul, exploring alternative investment vehicles becomes a prudent consideration.
2. Limited Access to Your Funds
A Roth 401(k) is primarily designed for long-term retirement savings. Following sound financial principles, it’s generally advisable to avoid interrupting the power of compounding returns unnecessarily. However, life is unpredictable, and situations may arise where accessing your savings becomes necessary.
If your retirement savings are exclusively in a Roth 401(k), accessing those funds before age 59 1/2 is restricted. While you can withdraw your original contributions from a Roth 401(k) at any time without incurring taxes or penalties, the earnings portion of your account are typically subject to both income taxes and a 10% penalty if withdrawn before age 59 1/2.
Unfortunately, Roth 401(k) withdrawals are treated proportionally as coming from both contributions and earnings. For example, if your account holds $100,000, with $75,000 representing your contributions, a $10,000 withdrawal would be considered $7,500 from contributions and $2,500 from earnings. That $2,500 earnings portion would then be subject to both your regular income tax rate and the additional 10% early withdrawal penalty.
Some 401(k) plans offer the option of a 401(k) loan. However, loan amounts are typically capped at the lesser of $50,000 or 50% of your vested account balance. You’ll also be required to pay interest on the loan, back to your own account, and some plans may restrict further contributions or employer matching until the loan is fully repaid.
In contrast, funds held in a taxable brokerage account offer significantly greater liquidity. You can access any amount at any time, and you will only owe capital gains taxes on any profits you’ve made when you sell investments.
3. Traditional 401(k)s Can Potentially Lead to Greater Savings
While the prospect of tax-free withdrawals in retirement is appealing, it’s crucial to take a holistic view of taxation throughout your life and retirement.
With a Roth 401(k), you pay income taxes on your contributions in the present, at your current marginal tax rate. Your marginal tax rate is essentially the tax bracket your last dollar of income falls into. For example, in 2024, an individual earning between approximately $62,000 and $115,000 might be in the 22% marginal tax bracket.
Conversely, withdrawals from a traditional 401(k) in retirement are taxed as ordinary income. However, the tax burden in retirement might be lower than your current marginal rate due to the progressive nature of income tax brackets. In retirement, your withdrawals are taxed starting at the lower tax brackets first. You benefit from the standard deduction, and then income is taxed at the 10% bracket, followed by the 12% bracket, and so on. Therefore, even a substantial withdrawal from a traditional 401(k) might result in a lower effective tax rate than your current marginal tax rate. For instance, withdrawing $100,000 from a traditional 401(k) might result in an effective tax rate closer to 13.8%.
Even if you anticipate tax rates potentially increasing in the future, a significant rise would be necessary to definitively make a Roth 401(k) the more tax-efficient choice in many scenarios. A careful assessment of your current tax situation, your expected retirement income needs, and potential future tax rate changes is essential to determine whether the tax advantages of a Roth 401(k) will truly translate into net savings for you.
The Roth 401(k) Has Its Merits
It’s important to acknowledge that Roth 401(k)s are not without their advantages. They can be a valuable tool for securing employer matching contributions on a tax-advantaged basis, and they can offer a degree of tax simplification in retirement. However, as with any financial decision, investors should thoroughly explore all available options and carefully evaluate whether the specific benefits of a Roth 401(k) outweigh its potential drawbacks in their individual circumstances.
