“What is a Roth 401(k)?” is a common question people ask when planning their retirement finances. Today’s article answers this question along with other important questions about this retirement plan option.
In this article:
- What Is a Roth 401(k)?
- Roth 401(k) vs 401(k): What Is Their Main Difference?
- Roth 401(k) vs Roth IRA: How Else Are They Different?
- How Much Can a Person Contribute Annually to a Roth 401(k)?
- When Can Employees Make Distributions from Their Roth 401(k)?
- Where Do Employers’ Matching Roth 401(k) Contributions Go?
- What Happens to a Roth 401(k) Plan’s Balance When Employment Ends?
- Why Should Employees Consider Investing in a Roth 401(k)?
What Is a Roth 401(K): A Beginner’s Guide to How It Works
What Is a Roth 401(k)?
This refers to an employer-sponsored retirement plan that’s a cross between a traditional 401(k) and a Roth IRA. Employees contribute to a Roth 401(k) using after-tax income.
The Roth IRA part of this retirement plan allows investments to grow without being taxed. And, as long as the employee is already 59 ½ years or older and has held the account for over five years, he or she can withdraw from this account during retirement without having to pay income taxes.
Roth 401(k) vs 401(k): What Is Their Main Difference?
The main difference between a Roth 401(k) and a traditional one is the income used to fund contributions.
- With a traditional 401(k), employees contribute income that hasn’t been taxed yet. They only pay taxes when they make withdrawals from the account later on, which include contributions and gains from such.
- Employees contribute to Roth 401(k) accounts with income that has already been taxed. As such, they don’t have to pay taxes on any qualified distributions or withdrawals later on.
Roth 401(k) vs Roth IRA: How Else Are They Different?
Roth 401(k) and a Roth IRA also differ when it comes to sponsorship.
- A Roth 401(k) requires sponsorship of an employer. Only employees whose employers sponsor Roth 401(k) plans can invest in such an account.
- On the other hand, anybody who makes money can open a Roth IRA. No employer sponsorship is required.
Another key difference between these two types of retirement plans is income limits. A person’s annual income can’t exceed a specific income limit if that person wants to contribute to a Roth IRA.
- A single person who earns more than $137,000 annually can’t contribute to any IRA, Traditional or Roth. If such a person earns more than $122,000 up to $137,000 annually, the maximum contribution limit is lower.
- Married couples who file taxes jointly and make more than $203,000 annually are also prohibited from contributing to Roth IRAs. For those who earn more than $193,000 up to $203,000 annually, their contribution limits go down, too.
Unlike Roth IRAs, Roth 401(k) accounts don’t qualify based on annual income. This makes a Roth 401(k) very attractive to high-earning employees who want the benefits of higher contribution limits and tax-free distributions later on.
Required Minimum Distributions
Another important difference between a Roth 401(k) and a Roth IRA is required minimum distributions. With a Roth 401(k), a person is compelled to them when they turn 70 ½ years old.
On the other hand, the IRS doesn’t compel retirees to take required minimum distributions fort Roth IRAs at any point in their lives. They can keep their funds in their Roth IRAs and continue to make them grow if they want to.
How Much Can a Person Contribute Annually to a Roth 401(k)?
Because a Roth 401(k) is a type of 401(k) account, the same contribution limit as a traditional 401(k) applies.
As of 2019, the annual maximum contribution limit for employees younger than 50 years is $19,000. For those who are 50 years and older, the limit’s $25,000, which allows catch-up contributions of up to $6,000.
However, these limits aren’t limits for each type of 401(k) account but are the aggregate limits for all 401(k) accounts.
A person with a traditional 401(k) only can contribute a maximum of $19,000 annually to that account if younger than 50 years old. One who’s 50 years or older can put in as much as $25,000 annually to the same account.
For a person with both Roth and traditional 401(k) accounts, he or she has to distribute the applicable annual contribution limits to those two accounts. That person may distribute the contribution limit equally or according to any desired combination with a maximum total of $19,000 or $25,000.
When Can Employees Make Distributions from Their Roth 401(k)?
There are two conditions that employees need to meet to make qualified distributions from their Roth 401(k) accounts:
- The investor must be at least 59 ½ years old or have suffered a specific disability.
- They must have owned the account for a minimum of five years.
What is a qualified distribution? A qualified distribution is one that meets the IRS’ conditions for making distributions or withdrawals from a retirement account.
The beneficiaries of employees who have Roth 401(k) plans can also make qualified withdrawals under two conditions:
- The owner of the Roth 401(k) plan has passed away.
- The Roth 401(k) has been under ownership by the owner for at least five years.
And when they turn 70 ½ years old, the IRS will compel the investor to make required minimum distributions every year.
Where Do Employers’ Matching Roth 401(k) Contributions Go?
Employer-matching 401(k) plans are very good ways to optimize one’s retirement savings and investments. And with a Roth 401(k), employers can match their employees’ contributions.
However, this comes with a caveat. Employer’s matching contributions all go to their employees’ traditional 401(k) accounts, even if they’re for Roth 401(k) plans.
This means the IRS will tax any distributions from employer-matching contributions, including gains from such contributions, in the future.
What Happens to a Roth 401(k) Plan’s Balance When Employment Ends?
Because a Roth 401(k) is an employer-sponsored retirement plan, termination of employment means termination of the plan. However, employees can rollover their Roth 401(k) account’s balances to a Roth IRA.
Why Should Employees Consider Investing in a Roth 401(k)?
Employees who are choosing between a traditional 401(k) and a Roth 401(k) need to make a challenging tax-related choice:
- Pay taxes now while contributing to a Roth 401(k) and enjoy tax-free distributions in the future; or
- Contribute more to a traditional 401(k) or enjoy a higher net take-home pay today, and pay a potentially higher tax rate later on in retirement.
Oftentimes, choosing between a traditional and Roth 401(k) plan boils down to one’s estimation of his or her retirement tax bracket, which can be lower or higher than their current tax bracket.
- Those who believe they’ll be in a lower tax bracket when retirement rolls around are better off choosing a traditional 401(k). Instead of paying a higher tax rate now, the investor can put it off until retirement, when they arrive at a lower tax rate or bracket.
- Investors who believe he or she will move to a higher tax bracket upon retirement benefit from contributing to a Roth 401(k) instead. By choosing a Roth 401(k), an employee can “lock in” on today’s lower tax rates.
Regardless of how strongly people believe about their future tax brackets and future tax rate changes, anything is possible. As such, employees should consider contributing to a Roth 401(k) and a traditional 401(k).
Aside from retirement tax rate or bracket considerations, another reason for considering a Roth 401(k) plan is income limit.
High-earning employees, or those earning more than $137,000 (single) or $203,000 (married and joint tax filers) annually, are disqualified from making Roth IRA contributions. While they can do backdoor Roth IRAs, it can be more tedious than just contributing to a Roth 401(k).
A Roth 401(k), on the other hand, doesn’t discriminate against high-income earning employees who want to enjoy tax-free retirement benefits. Whether employees make $70,000 or $500,000 annually, they can contribute to a Roth 401(k) and enjoy tax-free retirement finances.
Because it offers tax-free retirement benefits, doesn’t have income qualifications for contributing, and allows higher total annual contributions, a Roth 401(k) plan can be a very good way to optimize one’s retirement finances. As such, a Roth 401(k) can be a good addition to any employee’s retirement plan.
Do you think contributing regularly to a Roth 401(k) can help you maximize your retirement finances? Let us know in the comments section below!
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