What is a Roth 401(k)?

A Roth 401(k) is exactly what it sounds like: it’s a combination of a 401(k) and a Roth IRA.  Like a 401(k), it’s offered by an employer, contributions are taken out of your paycheck directly and invested in the company’s 401(k) plan.  One significant difference between a Roth 401(k) plan and a traditional 401(k) plan is the timing of the plan’s taxation. Roth 401(k)s and Roth IRAs allow you to make contributions to your retirement account with after-tax dollars. You don’t get the upfront tax break, but you avoid paying any taxes on your withdrawals after you retire.  That means there’s never any federal income tax on the growth in the account.  By contrast, the traditional 401(k) plan retirement savings was based on the concept of deferred compensation, whereby contributions come from pretax earnings.  You reduce current income for tax purposes and in exchange, agree to pay income taxes when you withdraw money from your account, both principal and earnings after you retire.

Contribution Amounts

The most distinguishing characteristic of 401(k)s, whether Roth or traditional, is the high contribution limit.  Contribution limits for a Roth 401(k) are the same as those for a regular 401(k). For 2017, the Roth 401(k) allows employees to put away up to $18,000 per year, and if you are age 50 or over, the ceiling is $24,000. The 401(k) limits apply on a per-person basis, so the combined total of your contributions to both traditional and Roth 401(k) accounts can’t exceed $18,000, or $24,000 if you’re at least age 50.  Compare these maximums to those for the Roth IRA.  The contribution limits for a 401(k) are roughly three times higher than that of a Roth IRA.  Roth IRA limits for individual retirement accounts are $5,500, and $6,500 if you are at least 50 years old.  Moreover, the ability to contribute to a Roth IRA is reduced or even eliminated if a taxpayer’s income exceeds $133,000 for single, and $196,000 for married filing jointly in 2017.

Distributions

A benefit of the Roth IRA is that the account can exist, essentially forever without any minimum distribution requirements during your life, unless you inherited the account.  The Roth IRA can be passed down to the next generation and provide tax-free earnings for that generation and the next.  On the other hand, with a Roth 401(k) plan, you must start taking distributions by the time you hit age 70½ — unless you’re still working and not a 5% owner in the company.  However, there are ways around this if you don’t need the money and prefer to keep your savings working for you tax-free.  You may roll the account over from a 401(k) directly to a Roth IRA.

Investment Options

Another Roth IRA advantage is you have more control over your investment choices compared to a Roth 401(k).  You have the option to choose from the universe of investments, including individual stocks and bonds, low-fee mutual funds, while Roth 401(k) plans are strictly limited to the funds your employers offer in the 401(k) plan.

Depending on the plan’s investment performance, you might be better off maximizing the match from your employer and then funding any remaining eligible retirement dollars into a Roth IRA.  That way, you can take advantage of better investment options if the funds are too limited in the employer’s plan.

How to Participate

If your employer offers a Roth 401(k) plan, to participate you simply designate some or all of your 401(k) elective deferrals as Roth contributions. Roth 401(k) plans are now offered by 47% of plan sponsors, according to a June 2016 report by the Transamerica Center for Retirement Studies.  Finally, if you are choosing between a Roth 401(k) plan and a Roth IRA, you ought to also think about the practical advantages of dollar-cost averaging into a Roth 401 (k) plan every pay period, rather than waiting to make a lump sum investment into a Roth IRA prior to tax time.  Because Roth 401(k) contributions are made each pay period, dollar-cost averaging can reduce the risk of incorrectly timing a lump sum investment, and that can lead to a lower average cost and greater long-term profit.

The Match in a 401(k)

Besides their high contribution limits, Roth 401(k)s have another advantage.  Your contribution can be matched by the employer up to a certain percentage.  It is essentially free money from the employer, on top of your elective deferrals.  However, if you are contributing to a Roth 401(k), the matching portion of the contribution will be treated as a traditional 401(k) contribution because it goes in pretax.  That means that every Roth 401(k) account essentially has a traditional component if the employer provides matching contributions.  The matches will be treated as ordinary income when withdrawn.

Your contributions to a designated Roth account are reported on your Form W-2, “Wage and Tax Statement.” Even though distributions from Roth 401(k) plans aren’t taxed, they’re reported on Form 1099-R, “Distributions from Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc.”

Rollovers for Roth 401(k)s

Other than the big after-tax difference, Roth 401(k)s work a lot like regular 401(k)s.  When you leave one job for another, you have the choice to keep your Roth 401(k) where it is with the former employer, to move it into your new employer’s plan, or rollover to a Roth IRA, where you will be subject to the same withdrawal rules.

An Excellent Tool

Roth 401(k) plans can be a great retirement savings tool, especially for high-income earners and for those concerned that their tax rate may be higher in retirement.  Roth contributions don’t reduce your tax bill now, but you can withdraw all of the money in the account tax-free after you reach age 59 ½ and have had the account for at least five years.  “You have more flexibility in retirement with Roth 401(k).” Says Karen Wong, senior tax manager at Buchbinder. “For example, if you need to take a lump sum distribution to cover your unexpected expenses, you can tap the Roth without any tax consequences because this distribution will not be included in your adjusted gross income.  However, if you take a lump sum from a traditional 401(k) or traditional IRA, the entire distribution will be subject to tax and might even put you in a higher tax bracket, therefore, you will need to withdraw more than you need to cover the additional taxes.” Your accounting professional can help you determine if a Roth 401(k) plan is right for you.

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