Key Takeaways:
- A Roth 401(k) is an option within employer-sponsored 401(k) plan that is funded with post-tax dollars.
- Roth 401(k) contributions are made with after-tax basis, but all qualified withdrawals (earnings included) made in retirement are tax-free.
- There is no income limit to contribute to a Roth 401(k) unlike a Roth IRA.
- The amount you may contribute to a Roth 401(k) is much greater than the amount possible in a Roth IRA ($22,500 vs. $6,500 respectively in 2023).
- 401(k) participants may choose to contribute some, all, or none to the Roth 401(k) or tax-deferred options. All employer contributions (match) are made tax deferred.
What Is a Roth 401(k)?
A Roth 401(k) allows an employee to make after-tax contributions to her or his 401(k) account, up to the current employee contribution limits ($22,500 in 2023). Once in retirement, these funds aren’t taxed—even the earnings—during withdrawal.
What Are After-tax Contributions in a Roth 401(k)?
Roth contributions are investments made with after-tax monies; however, when monies are withdrawn in retirement, they are tax-free -- earnings and all. Investment growth including interest, dividend and capital gains accumulate tax-free. Common examples of vehicles that offer the option for Roth contributions are 401(k) plans with the Roth 401(k) feature and Roth IRAs. Roth IRAs do have some earning limits that can restrict who can utilize it. Roth 401(k)s can be used by any investor with access to a 401(k) with the Roth option no matter their earnings. Investors in a 401(k) can choose how much they want to contribute tax-deferred or in the Roth 401(k). Note that any and all employer contributions are made on a tax-deferred basis by law.
What Are the Benefits of a Roth 401(k)?
Roth 401(k) plans allow employees to make after-tax contributions to a 401(k), up to the current employee contribution limits ($22,500 in 2023). Once in retirement, these funds aren’t taxed – even the earnings – during withdrawal.
Roth 401(k) vs. Roth IRA
| Attributes | Roth 401(k) | Roth IRA |
|---|---|---|
| Contribution Limit (2023) | $22,500 | $6,500 |
| Age 50+ Catch-up Amount (2023) | $7,500 | $1,000 |
| Roth Income Limit | None | $138,000* |
* Beginning at $138K, the amount you are allowed to contribute begins to decrease, hitting $0 at $153K for singles (range is $218K to $228K for married couples filing jointly). This is based on Modified Adjusted Gross Income (MAGI).
If you don’t have the Roth option in your company 401(k) plan, it’s a great idea to request it. This typically requires an amendment to the plan that’s a minor cost to the business owner.
Roth 401(k) versus Traditional 401(k)
| Roth 401(k) | Traditional 401(k) (tax-deferred) | |
|---|---|---|
| Contribution Tax Treatment | You contribute after-taxes; there is no tax benefit in the current year. | You contribute before tax which lowers your current adjusted gross income. You’ll have more take home pay in the current tax year than if you made all Roth 401(k) contributions. |
| Withdrawal Tax Treatment | No taxes on your distributions in retirement. To be IRS qualified, you must have established the Roth 401(k) five or more years ago and you are taking the distribution on or after reaching age 59 ½ or due to disability or death. | Your distributions are taxed as ordinary income upon reaching retirement age (59 ½ years old). Note that if you take withdrawal before retirement age you will typically be subject to an added 10% penalty. |
Roth tax rules are the exact opposite of how traditional tax-deferred 401(k) contributions work. Your tax-deferred contributions will be taxed when you withdraw the money at retirement; however, you receive no tax deduction on Roth contributions. The benefit is that your Roth withdrawals (including investment gains) can be taken tax-free when you reach retirement.
It’s important to note that any employer match or profit sharing into your 401(k) will always be on a tax-deferred basis as required by law.
Roth 401(k) Has No Income limits
Unlike the Roth IRA, there is no income limit for contributing to a Roth 401(k). Anyone can have one if their employer’s plan offers this feature. To invest in a Roth IRA and make the maximum contribution, modified adjusted gross income must be below $138,000 if single or $218,000 if married and filing a joint return.
Tax Hedging Your Nest Egg and Maximizing Your Money
It’s anyone’s guess what tax rates will look like 10, 20, or 30 years from now – let alone knowing what tax bracket you’ll wind up in. Many believe tax rates are only headed up in the years ahead. Others aren’t so sure. If you’re early in your career and climbing the corporate ladder, it’s likely you’ll graduate to higher tax rates by the time you retire.
So, whether you believe tax rates are headed up and/or are climbing the job ladder, a smart strategy can be to divide your contributions between tax-deferred and the after-tax Roth 401(k). This allows you to hedge your retirement savings and enable more options on how to use your money and manage tax implications in retirement. For instance, you can take money out of the Roth during years when you need to spend more and your tax bracket is higher, and then use the traditional 401(k) funds when your spending is lower.
The Roth 401(k) is a nice big brother to have on your side. There’s no better time than now to consider your needs for the future and be in a strong position to get the most out of your savings.
Deadlines for Roth 401(k)
Generally, the last business day of the year (in December)is the deadline for employees to make Roth 401(k) contributions.
How Can We Help?
Choosing the right 401(k) plan for your small business can be challenging. Give us a call - we’ll take the time to learn about your business and help you find the right plan to achieve your retirement goals.
Happy saving!