The Roth 401(k) dilemma: Tax-exempt but tax inefficient

March 19, 2025 - 8 min read

Roth 401(k)s are tax inefficient. Here's 4 workarounds.

Vice President, Investment Strategist – Natixis Investment Managers Solutions

The Roth 401(k) is held in high regard among financial advisors as a powerful investment account to shelter retirement assets from future taxation. But it has a problem: The inability to specify a different asset allocation for the Roth 401(k) from the pretax 401(k) makes these tax-exempt accounts less efficient than they appear.

In this article, I’ll explain the importance of asset location and tax diversification, show how the Roth 401(k) underperforms the optimal structure, and offer some ideas on how to work around it for a more tax-efficient portfolio.

Key takeaways

The inability to specify different asset allocations for Roth 401(k) and pretax 401(k) accounts results in tax inefficiency and reduced after-tax wealth.
Placing tax-efficient assets in taxable accounts and tax-inefficient assets in tax-deferred accounts may optimize after-tax returns.
A mix of taxable, tax-deferred, and tax-exempt accounts provides flexibility to manage tax bills during retirement and acts as a hedge against changing tax rates.

What is a Roth 401(k)?

A Roth 401(k) is a savings vehicle for those who expect their marginal tax rate be higher in the future or want tax diversification to optimize withdrawals during retirement. Employees pay taxes on their contributions today and then never have to worry about paying taxes on the growth, income, or distribution of those dollars.

A designated Roth account is a separate account within a company’s retirement savings plan, i.e., 401(k). Employees can contribute to the Roth account through payroll deduction and receive identical tax treatment as a Roth IRA but benefit from higher contribution limits and no income limit. See Appendix – Roth 401(k) vs. Roth IRA at the end of this article.

Retirement account types and asset location

There are three main types of retirement accounts investors can choose to save in: taxable, tax-deferred, and tax-exempt. Each differs in terms of its flexibility and tax status.

Because each account has a different tax treatment, there’s an opportunity to tailor the asset classes and investment vehicles in these accounts to optimize for after-tax return. While asset allocation refers to the mix of stocks, bonds, and other assets in a portfolio, asset location is about ensuring each account holds the most efficient asset.

Smart asset location strategies can help reduce a client’s tax bill. For example, a corporate bond’s interest held in a taxable account will be taxed at the client’s ordinary income rate, up to 37% in 2025. That same bond held in a tax-deferred IRA would not be subject to taxes on the interest but would be taxed when withdrawn from the account.

Tax-inefficient assets that generate ordinary income such as interest, nonqualified dividends, and short-term capital gains are ideal for tax-deferred accounts. Taxable bonds such as government and corporate bonds are the quintessential case and are often held in tax-deferred accounts.

Tax-efficient assets that generate little ordinary income or generate long-term capital gains are ideal for taxable accounts. Municipal bonds, whose interest is exempt from federal income tax, is the prime example. A direct indexing strategy that offers systematic tax loss harvesting is another good candidate for a taxable account because it’s unlikely to generate much ordinary income or net capital gains.

Graphic showing tax-efficient vs. tax inefficient assets.

The chart below looks at the two tax rates applicable to investors – Ordinary Income in purple and Long-Term Capital Gains in teal. In general, if the asset in question will generate and distribute something that will be taxed at the purple line, it should be considered for a tax-deferred account.

Line chart showing two tax rates applicable to investors: Ordinary income and Long-term capital gains.

Note: Does not include the 3.8% net investment income tax (NIIT), which applies to individuals, estates, and trusts that have net investment income above applicable threshhold amounts. *Capital gains rate is 0% up to $96,700. Sources: IRS, Natixis.

Why tax diversification is important

Financial planners generally recommend tax diversification – having money in a mix of taxable, tax-deferred, and tax-exempt accounts – as a hedge against changing tax rates. Tax diversification also provides flexibility to manage your tax bill during retirement when making withdrawals to cover living expenses.

For example, a recent retiree who is yet to take Social Security, not yet taking required minimum distributions (RMDs), and has no other income will be subject to 0% tax on realized long-term capital gains up to $96,700 (married filing jointly). If they only had a tax-deferred account and no taxable assets, they would be forced to pay ordinary income tax on the withdrawal of their living expenses starting at a 10% rate.

Tax-exempt retirement accounts

Tax-exempt accounts, like the Roth IRA and Roth 401(k), are a special case. You might just extend the above logic and place ordinary income generators (such as bonds) in the tax-exempt bucket. But time horizon, expected returns, and expected future tax rates should also be considered.

Instead, these accounts should hold the asset classes with the highest expected returns – typically stocks over bonds. Growth stocks, small-/mid-caps, emerging markets, and even cryptocurrency are ideal candidates. Because this money is shielded from future taxation, a dollar of growth is worth a dollar to the investor. A dollar of growth in a tax-deferred account is worth only 59.2 cents for those in the highest 37% tax bracket and subject to the 3.8% NIIT.

The investor will want to not only place high growth assets in their tax-exempt retirement account but also let that money compound as long as possible before withdrawing it.

Roth 401(k) administrative drawback

So, what’s the problem with the Roth 401(k)?

Most custodians don’t give participants the ability to customize their asset allocation for their Roth 401(k). All that important asset location stuff can’t be used in a Roth 401(k), which means investors are leaving money on the table – or, more precisely, paying more in taxes than necessary. This is real money being wasted because of an administrative issue. DOGE to the rescue?!

Beyond a couple of Reddit comments, I’ve yet to hear of or see a 401(k) plan that allows for more than one asset allocation. While the plan participants can choose how to invest their funds (stock, bonds, target-date funds) and choose where their contributions go (pretax 401(k) or Roth 401(k)), they cannot dictate a separate asset allocation for each bucket.

The result is a less-than-ideal, inefficient use of the Roth feature. Because of this, the Roth 401(k) becomes inferior to the Roth IRA insomuch as the asset allocation is hamstrung. A plan participant with an allocation to bonds (a lower expected return than stocks) would ideally have those on the pretax 401(k) side and not on the Roth 401(k) side. But the standard practice is that they’d have bonds on both sides pro rata.

Example

Suppose Sean has $1,000,000 in his 401(k) with $700,000 in the pretax 401(k) and $300,000 in the Roth 401(k). His target asset allocation is 80% stocks and 20% bonds. Stocks are expected to return 10% and bonds 5% for a portfolio expected return of 9%. In retirement, he expects to be in the top tax bracket paying 37% on ordinary income plus an additional 3.8% in NIIT for a total tax of 40.8%.

Assuming no other contributions to his account, in 20 years his pretax value will be $5.6 million and shrink to $4.0 million after taxes.

However, if he was able to optimally use asset location techniques in his Roth 401(k), he wouldn’t own any bonds in that account. He’d put $300,000 in stocks (or $60,000 more than the current set-up) in the Roth 401(k) and hold no bonds there. That $300,000 will compound at 10% over 20 years and never being taxed.

The result is a total after-tax portfolio value of $4.16 million, or $160,958 more than the suboptimal (current) setup.

Sean’s overall asset allocation is the same in both scenarios: He maintained 80% in stocks and 20% in bonds over the period. His portfolio return didn’t change either – both accounts grew at 9% over the 20-year period. But because of the tax haircut in Year 20 on the pretax side, he was disadvantaged because he had to hold more stocks in that account than optimal. That cost him $160,958 in after-tax dollars because his plan custodian wouldn’t let him asset locate within his 401(k).

Potential Roth 401(k) work arounds

Given the current administrative issue, what are some potential solutions?

Request custom allocation: Ask your employer to allow separate asset allocations for pretax 401(k) and Roth 401(k) contributions. This may not be something an employer can change, but they can put pressure on the plan’s custodian to support this feature.
Overallocate to equities: Put more of your 401(k) contribution into the Roth 401(k) and have a higher percentage in equities while holding bonds in a traditional IRA or Rollover IRA accounts. This may be impractical due to contribution limits and larger 401(k) balances compared to IRAs.
Use taxable accounts: Instead of making after-tax contributions to a Roth 401(k), contribute to a taxable account and hire a direct indexing manager to actively tax-loss harvest an index-based equity portfolio. This can provide similar gain deferral benefits, and when those equities are eventually needed, they’ll be taxed at preferential long-term capital gains rates.
Roll over to an IRA: If you leave your employer, you can roll over your Roth 401(k) into a Roth IRA, giving you more control over asset allocation and tax efficiency.

Conclusion

While the Roth 401(k) offers significant tax advantages, it doesn’t let investors optimize based on asset location. The inability to designate different asset allocations for the Roth and pretax portions of the 401(k) results in suboptimal tax outcomes and unnecessarily reduces after-tax wealth. To mitigate this issue, participants can consider strategies such as overallocating equities in the Roth 401(k) and holding bonds in other tax-deferred accounts, or even rolling over Roth 401(k) funds into a Roth IRA upon leaving an employer. By understanding and addressing these challenges, investors can better optimize their portfolios for tax efficiency and long-term growth.

Appendix – Roth 401(k) vs. Roth IRA

While both a Roth 401(k) and a Roth IRA are retirement accounts funded with after-tax dollars, there are a few key differences.

Roth 401(k) stats

The Plan Sponsor Council of America estimates 93% of 401(k) plans offer a designated Roth account. While 21% of plan participants currently contribute to their Roth 401(k), next year certain “catch-up” contributions will be required to go into a Roth 401(k).¹

New SECURE Act 2.0 provision effective 2026

If you earned more than $145,000 in the previous calendar year and are age 50 years or older, catch-up contributions to a workplace plan must be made into a Roth 401(k) with after-tax dollars.

¹ Source: www.psca.org/industry-content/surveys/annual-401k-survey

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This material is provided for informational purposes only and should not be construed as investment advice. Any opinions or forecasts contained herein reflect the subjective judgments and assumptions of the authors only and do not necessarily reflect the views of Natixis Investment Managers, or any of its affiliates. There can be no assurance that developments will transpire as forecastsed and actual results will be different. Data and analysis does not represent the actual or expected future performance of any investment product. We believe the information, including that obtained from outside sources, to be correct, but we cannot guarantee its accuracy. The information is subject to change at any time without notice.

Diversification does not ensure a profit or guarantee against a loss.

This information does not consider any investor's particular investment objectives, strategies, tax status or investment horizon. You should consult your tax and financial advisor.

DOGE: Department of Government Efficiency

MAGI: Modified Adjusted Gross Income

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