Pay it Now or Pay it Later: Roth 401(k) Basics
Thursday, December 10th, 2020
Employers can offer 401(k) plan participants the opportunity to make Roth 401(k) contributions. If you’re lucky enough to work for an employer that offers this option, Roth contributions could play an essential role in maximizing your retirement income.

What is a Roth 401(k)?

A Roth 401(k) is simply a traditional 401(k) plan that accepts Roth 401(k) contributions. Roth 401(k) contributions are made on an after-tax basis, just like Roth IRA contributions. This means there’s no up-front tax benefit. Still, if certain conditions are met, your Roth 401(k) contributions and all accumulated investment earnings on those contributions are free from federal income tax when distributed from the plan. (403(b) and 457(b) plans can also allow Roth contributions.)

Who can contribute?

Unlike Roth IRAs, where you can’t contribute if you earn more than a specific dollar amount, you can make Roth contributions, regardless of your salary level, as soon as you are eligible to participate in the 401(k) plan. And while a 401(k) plan can require employees to wait up to one year before they become eligible to contribute, many plans allow you to contribute beginning with your first paycheck.

How much can I contribute?

There’s an overall cap on your combined pretax and Roth 401(k) contributions. In 2021 you can contribute up to $19,500, or 26,000 if you’re age 50 or older, to a 401(k) plan. You can split your contribution between Roth and pretax contributions any way you wish.

For example, you can make $10,000 of Roth contributions and $9,500 of pretax 401(k) contributions. It’s up to you. Keep in mind that if you also contribute to another employer’s 401(k), 403(b), SIMPLE, or SAR-SEP plan, your total contributions to all of these plans, both pretax and Roth, can’t exceed $19,500 in 2021. It’s up to you to make sure you don’t exceed these limits if you contribute to more than one employer’s plans.

Can I also contribute to an IRA?

Yes. Your participation in a 401(k) plan has no impact on your ability to contribute to an IRA (Roth or traditional). You can contribute up to $6,000 to an IRA in 2021, or $7,000 if you’re age 50 or older. It is important to note that your ability to contribute to a Roth IRA may be limited if your modified adjusted gross income (MAGI) exceeds certain levels. Similarly, your ability to make deductible contributions to a traditional IRA may be limited if your MAGI exceeds certain levels and you or your spouse participate in a 401(k) plan.

Are distributions tax-free?

Because your Roth 401(k) contributions are made on an after-tax basis, they’re always free from federal income tax when distributed from the plan. But the investment earnings on your Roth contributions are tax-free only if you meet the requirements for a “qualified distribution.”

In general, a distribution from your Roth 401(k) account is qualified only if it satisfies both of the following requirements:

– It’s made after the end of a five-year waiting period

– The payment is made after you turn 59½, become disabled, or die

The five-year waiting period for qualified distributions starts on January 1 of the year you make your first Roth contribution to the 401(k) plan. For example, if you made your first Roth contribution to your employer’s 401(k) plan in December 2020, your five-year waiting period begins January 1, 2020, and ends on December 31, 2024. If you participate in more than one Roth 401(k) plan, your five-year waiting period is generally determined separately for each employer’s plan. If you change employers and directly rollover your Roth 401(k) account from your prior employer’s plan to your new employer’s plan, the five-year waiting period for your new plan starts with the year you made your first contribution to the earlier plan.

If your distribution isn’t qualified (for example, if you receive a payout before the five-year waiting period has elapsed), the portion of your distribution that represents investment earnings on your Roth contributions will be taxable. It will be subject to a 10% early distribution penalty unless you’re 59½, or 55 in some cases or another exception applies. You can generally avoid taxation by rolling all or part of your distribution over into a Roth IRA or another employer’s Roth 401(k) or 403(b) plan if that plan accepts Roth rollovers. State income tax treatment of Roth 401(k) contributions may differ from the federal rules.

If you contribute to both a Roth 401(k) and a Roth IRA, a separate five-year waiting period applies to each. Your Roth IRA five-year waiting period begins with the first year that you make a regular or rollover contribution to any Roth IRA.

What about employer contributions?

Employers don’t have to contribute to 401(k) plans, but many will match all or part of your contributions. Your employer can match your Roth contributions, your pretax contributions, or both. But your employer’s contributions are always made on a pretax basis, even if they match your Roth contributions. Your employer’s contributions and investment earnings on those contributions are not taxed until you receive a distribution from the plan. Your 401(k) plan may require up to 6 years of service before you fully own employer matching contributions.

It is important to note that if your plan is a SIMPLE 401(k) plan, a safe-harbor 401(k) plan, or includes a qualified automatic contribution arrangement (QACA), your employer is required to contribute on your behalf. There will be special vesting rules that apply as well.

Should I make pretax or Roth 401(k) contributions?

When you make pretax 401(k) contributions, you don’t pay current income taxes on those dollars (which means more take-home pay than an after-tax Roth contribution of the same amount). But your contributions and investment earnings are fully taxable when you receive a distribution from the plan. In contrast, Roth 401(k) contributions are subject to income taxes upfront, but qualified distributions of your contributions and earnings are entirely free from federal income tax.

Which is the better option depends upon your situation. If you think you’ll be in a similar or higher tax bracket when you retire, Roth 401(k) contributions may be more appealing since you’ll effectively lock in today’s lower tax rates. However, if you think you’ll be in a lower tax bracket when you retire, pretax 401(k) contributions may be more appropriate. Your investment horizon and projected investment results are also important factors. A financial professional can help you determine which course is best for you.

Whichever you choose, Roth or pretax, make sure you contribute as much as necessary to get your employer’s maximum matching contribution. This is virtually free money that can help you reach your retirement goals that much sooner.

What happens when I terminate employment?

When you terminate employment, you generally forfeit all contributions that haven’t vested. “Vesting” means that you own the contributions. Your contributions, Roth and pretax, are always 100% vested. But your 401(k) plan may require up to 6 years of service before you fully vest in employer matching contributions, although some plans have a much faster vesting schedule.

When you terminate employment, you can generally leave your money in your 401(k) plan, although some plans require that you withdraw your funds when you reach the plan’s average retirement age, which is typically 65. Your plan may also “cash you out” if your vested balance is $5,000 or less, but if your payment is more than $1,000, the plan must generally roll your funds into an IRA established on your behalf, unless you elect to receive your payment in cash. This $1,000 limit is determined separately for your Roth 401(k) account and the rest of your funds in the 401(k) plan.

You can also roll all or part of your Roth 401(k) dollars over to a Roth IRA and your non-Roth dollars to a traditional IRA. You may also be able to roll your funds into another employer’s plans that accept rollovers.

What else do I need to know?

Like pretax 401(k) contributions, your Roth 401(k) contributions and investment earnings can generally be paid from the plan only after you terminate employment, attain age 59½, become disabled, or die. You may be eligible to borrow up to one-half of your vested 401(k) account, including your Roth contributions.

You may be able to make a hardship withdrawal if you (or your spouse, dependents, or plan beneficiary) have an immediate and heavy financial need. But this should be a last resort. A 10% penalty may apply to the taxable amount if you’re not yet age 59½, and you may be suspended from plan participation for six months or more. Unlike Roth IRAs, you must begin taking distributions from a Roth 401(k) plan after reaching age 70½.

In some cases, you may wait until after you retire. You can still generally roll over your Roth 401(k) dollars into a Roth IRA if you don’t need or want the lifetime distributions. Depending on your income, you may be eligible for an income tax credit of up to $1,000 for amounts you contribute to the 401(k) plan. Your assets are generally fully protected from creditors.

Employers aren’t required to make Roth contributions available in their 401(k) plans. Be sure to ask your employer if they consider adding this exciting new feature to your 401(k) plan.

The Takeaway

When planning how to manage your retirement funds, you should work with a financial planner. They will be able to help you crunch the numbers and make the best decision for your financial future. They can help you understand the differences between retirement funds and which one will be best for you.