Roth 401(k) retirement plans

The basics of Roth 401(k) retirement plans

Roth retirement plans are popular with investors who want to grow their retirement savings on a tax-free basis and also withdraw income tax-free.

While many are familiar with Roth IRAs, Roth plans are also available with most other types of qualified retirement plans, including 401(k)s.

Like with a Roth IRA, a Roth 401(k) does not provide provide an immediate tax deduction for contributions. However, the investment gains within the account are tax-free, as are the withdrawals made during retirement provided the account is held for at least five years and made:

On account of disability; or
On or after death; or
On or after the account holder reaches age 59 1/2.

This provides a potential benefit for young and moderate-income workers who are in low tax brackets. The pre-tax contributions on a traditional 401(k) may not save these individuals much on their tax bill, because they’re in a lower tax bracket, and likely can’t contribute much to their accounts. But they will benefit later when they make withdrawals because they won’t pay any taxes on the income.

On the other hand, those who believe they will be in a lower tax bracket in retirement than they are currently will likely benefit more from a traditional 401(k) because they will save on taxes now and likely pay a smaller tax bill in retirement.

Experts say one of the advantages a Roth 401(k) has over a traditional 401(k) is its flexibility. One example is the retiree who wants to withdraw a sizable amount during retirement. Because the withdrawals on a regular 401(k) are full taxed as ordinary income, such a withdrawal could move the retiree up to a higher tax bracket. This won’t happen with a Roth 401(k) since there are no taxes on withdrawals if the requirements listed above are met. Early withdrawals on a Roth 401(k) are treated the same as those on a traditional 401(k) plan.

One factor that makes Roth 401(k)s more complicated than traditional plans is how employer matches are treated. Employer matches to a Roth 401(k) are made with pre-tax dollars, just as they are with traditional plans. This requires those funds to be placed in a separate account than the employee contributions to the Roth account. The withdrawals from the employer match account will, therefore, be taxed as ordinary income, just as if it was in a traditional 401(k).

Roth 401(k) vs. Roth IRA
Roth IRAs and 401(k)s offer the advantage of tax-free growth and withdrawals, but there are three main distinctions:

Income limits. There are no income limits to participate in a Roth 401(k) plan. To participate in a Roth IRA, on the other hand, a single filer can have adjusted growth income no higher than $132,000, while married filers are limited to AGI of $194,000 (limits are for 2016 tax year).

Contribution limits. The contribution limits on a Roth 401(k) plan are the same as a traditional 401(k). For 2016, a person can contribute $18,000 for the year to a Roth 401(k) if he or she is under the age of 50, and $24,000 if age 50 or older. Keep in mind that if you have multiple retirement plans, the annual contribution limits apply to all of them; you cannot make an $18,000 contribution to one plan and a similar contribution to another.

Roth IRAs, on the other hand, have much stricter contribution limits. For 2016, a person can contribute no more than $5,500 for the year if under the age of 50, or $6,500 if age 50 or older.

Required minimum distributions. Participants in a Roth 401(k) will need to begin taking a minimum distribution from their account no later than age 70 1/2. Roth IRA participants can leave their money in the account as long as they wish.

One way to get the best of both Roth plans is to take advantage of a direct rollover after you leave your employer. When you change jobs or retire, you have the option of rolling over your Roth 401(k) into a Roth IRA. Once the funds are in the Roth IRA, there are no required minimum distributions like there would be if you left the funds in the 401(k) plan.

It is important to note that if you rolling over the Roth 401(k) funds into a new Roth IRA, you will have to wait five years before making a tax-free withdrawal. If you roll over the funds into an existing Roth IRA, the rollover will assume the same holding period.