What is a Roth 401(k)?

One of the great advantages of saving in your 401(k) plan is the ability to set aside pretax money from your paycheck. So, why do some plans offer you the option to save after-tax money in a Roth 401(k)? You may benefit from saving all your money before tax, all of it after tax, or some of each. We’ll help you sort through deciding which strategy may be right for you.

Basics of retirement planning with a Roth 401(k)

If your plan allows a Roth 401(k) and you’re thinking about adding these contributions to your retirement savings strategy, understanding some of the basics is a good place to start.

What is a 401(k)?

A 401(k) plan is an employer-sponsored retirement savings account that lets you contribute money directly from your paycheck before taxes have been taken out. When you want to withdraw money in retirement, you pay federal income tax on your contributions and any money they’ve earned.1 The key advantage here is that the income tax you’ll pay in retirement may be lower than the tax you pay on income during your working years. 

What is a Roth 401(k)?

A Roth 401(k) plan is an employer-sponsored retirement savings account that lets you contribute money directly from your paycheck after taxes have been taken out. Because you pay ordinary income taxes on it now, as long as your withdrawals are qualified, you don’t have to pay federal income tax when you want to withdraw your contributions—and any money you earn on those contributions—after you retire.

Is a Roth 401(k) different from a Roth IRA?

There are a few key differences to be aware of.

  • Availability: Roth 401(k)s are only available through an employer-sponsored retirement program—although not all employers offer this option. But you can purchase a Roth IRA on your own, from a financial services company. 
  • Annual contribution limits: Roth 401(k)s allow you to contribute more per year than Roth IRAs.
  • Income restrictions: There’s no income restriction limiting who can contribute to a Roth 401(k), but there is for a Roth IRA.
  • Required minimum distributions (RMDs): Roth 401(k)s require that you take a minimum distribution starting when you turn 72 (if born after June 30, 1949) or 70½ (if born before July 1, 1949), but, in general, Roth IRAs don’t. 
  • Investment options: With a Roth 401(k), you can only choose investments that are offered in your employer-sponsored plan. Roth IRAs may offer you more options.  

Why would I contribute to a Roth 401(k)?

Generally, if you think your income-tax rate may be the same or higher in your retirement, you might consider making Roth 401(k) contributions instead of traditional 401(k) contributions.

How does a Roth 401(k) work?

If you opt to save in a Roth 401(k) account, you won’t experience any immediate tax advantages; however, when you take a qualified distribution—you won’t pay any federal income taxes on the contributions or their earnings.2 To take a qualified distribution, you must be at least 59½ years old or become disabled (or die), and the account must meet the five-year clock rule. The five-year clock begins with your first Roth 401(k) contribution made to the plan (or made to another qualified retirement plan, if it was rolled over to your current plan)—once five years pass, the account has met the rule. You may want to contact your plan consultant or financial or tax professional for specific details on the five-year rule and whether any special rule may apply.

Your Roth 401(k) distributions are also excluded as taxable income when Social Security is calculated.   

How the options compare

Because Roth 401(k) is a hybrid of a traditional 401(k) and Roth IRA, it’s helpful to see how they all compare.

Facts about … Roth 401(k) Traditional pretax 401(k) Roth IRA
Income limits N/A N/A

Income restrictions apply3

Contributions After tax Pretax After tax
Contribution limits

$19,500

Age 50+: $26,0004

$19,500

Age 50+: $26,0004

$6,000

Age 50+: $7,000

Investment earnings Tax free5 Tax deferred1 Tax free5
Distributions Qualified = tax free5 Taxed at withdrawal1 Qualified = tax free6
RMDs

In general, must start at 72 years of age7

In general, must start at 72 years of age7 Doesn’t apply, except for distributions made following death of the Roth IRA account holder

Is a Roth 401(k) right for you? 

Roth 401(k)s combine much of the ease and benefits of a traditional 401(k)—such as automatic contribution deductions from your paycheck and no income limits—with the after-tax treatment of a Roth IRA. If your employer offers a Roth 401(k), you may want to consider contributing to the Roth after-tax account, depending on your expected tax bracket, when you believe you’ll be making withdrawals or if you want to have multiple tax strategies to work with as part of your retirement savings approach. Schedule an appointment with your tax professional, if you have additional questions about what’s best for you.

 

1 Ordinary income taxes are due at withdrawal. Withdrawals before the age of 59½ may be subject to an early distribution penalty of 10%.  2 In this document, all tax disclosures regarding Roth 401(k) contributions are limited to the federal income-tax code and, in particular, all references to tax-free treatment of qualified distributions are intended to refer to the treatment of such distributions at the federal level only.  3 Income restrictions apply to Roth IRA contributions. That limit is phased out between $196,000 and $206,000 for married participants who file jointly, and $124,000 to $139,000 for single filers. 4 In 2020, you can save an annual total of $19,500 (or $26,000, if you’re age 50 or older) through pretax contributions, Roth contributions, or a combination of both.  5 A participant must satisfy the five-year holding period and attain age 59½, die, or become disabled in order to be eligible to receive a tax-free, qualified Roth distribution.  A participant must satisfy the five-year holding period and attain age 59½, die, or become disabled, or be a first-time home buyer ($10,000 lifetime limit), in order to be eligible to receive a tax-free, qualified Roth distribution. This is for individuals who attain age 70½ after December 31, 2019.

The content of this document is for general information only and is believed to be accurate and reliable as of the posting date, but may be subject to change. It is not intended to provide investment, tax, plan design, or legal advice (unless otherwise indicated). Please consult your own independent advisor as to any investment, tax, or legal statements made herein.

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