- Chris Cyndecki CFA, CFP®
Many employers are now offering the Roth 401(k) plan as a vehicle for retirement savings. The plan's popularity has skyrocketed in recent years. How Does It Work? Employee contributions to the Roth 401(k), typically made via payroll deductions, go into the account on an after-tax basis.
Employees pay income taxes today at their marginal tax rate on the money that goes into the plan. These contributions grow tax free, and the taxpayer will not have to pay taxes upon distribution in retirement. Employer matching contributions are made on a pre-tax basis and are placed in a separate bucket. The money in this bucket will be subject to ordinary income taxes when distributions are taken in retirement (just like a traditional 401(k) or IRA). Certain employers will allow Roth conversions within the plan, enabling a person to convert the match portion to after-tax status (pay tax on employer match today). However the employee must be careful with in-plan Roth conversions, because employer contributions are usually subject to a vesting schedule. Employees are entitled to the match only after fulfilling the requirements of the schedule. If the employee leaves the employer before the match is fully vested, the taxes paid on the converted, unvested match portion would be lost. Rules
For the 2015 tax year, an employee's total contribution between a traditional 401(k) and Roth 401(k) cannot exceed $18,000. There is a $6000 catch-up provision for people over age 50, increasing the total allowed contribution to $24,000. These limits also apply to elective deferral contributions made to another employer's 401(k), 403(b), SIMPLE, or profit-sharing plan.
There is no income phase out for the Roth 401(k) in determining eligibility (unlike the Roth IRA).
Qualified distributions occur when the individual has reached age 59.5, died, or become disabled AND at least 5 years after the first Roth contribution was made (5 year period starts January 1st of initial contribution year).
Non-qualified distributions are assessed on a pro-rata basis (unlike the Roth IRA where contributions come out first). Each distribution will be assigned a % contribution and a % earnings, both totaling 100%. The contribution portion will always come out tax-free and penalty-free, however the earnings portion will be subject to ordinary income taxes and a 10% IRS penalty.
The Roth 401(k) is subject to Required Minimum Distributions (RMDs) at age 70.5. The taxpayer can avoid RMDs by rolling the Roth 401(k) into a Roth IRA.
When Does It Make Sense? Many individuals contribute to a traditional 401(k) during peak earnings years to defer taxes until retirement when their marginal tax rates become lower. People in the early stages of their careers, expecting to make more money in the future, may benefit from contributing to a Roth 401(k). We recommend speaking with your financial planner or CPA to figure out what makes the most sense in your specific situation.