What is a 'Roth 401(k)'
A Roth 401(k) is an employer-sponsored investment savings account that is funded with after-tax money up to the contribution limit of the plan. This type of investment account is well-suited to people who think they will be in a higher tax bracket in retirement than they are now. The traditional 401(k) plan is funded with pretax money which results in a tax levy on future withdrawals.
BREAKING DOWN 'Roth 401(k)'Employee contributions are made using after-tax dollars with no income limitations to participate. A Roth 401(k) is subject to contribution limits based on the individual’s age. For example, the contribution limit for individuals up to age 50 in 2015 was $18,000 per year. Individuals older than 50 could contribute a total of $24,000 per year, and the additional $6,000 of eligible contribution room is called catch-up contributions. Withdrawals of any contributions and earnings are not taxed as long as the withdrawal is a qualified distribution. Distributions are required for individuals at least 70 ½ years old unless the individual is still employed and not a 5% owner of the business.
Contributions and earnings in a 401(k) are eligible to be withdrawn without an income tax assessment as long as certain criteria are met. The Roth 401(k) account must have been held for at least five years. In addition, the withdrawal must have occurred on the account of a disability, on or after the death of an account owner, or upon an account holder reaching the age of at least 59 ½.
Roth 401(k) Vs. Traditional 401(k)
The main difference between a Roth 401(k) and a Traditional 401(k) relates to the taxation of funding and distributions. When a Traditional 401(k) is funded, the account holder is not taxed on the contribution. This amount is deducted from the individual’s federal income tax return. Alternatively, contributions made to a Roth 401(k) are still taxed upon the contribution being made. When a distribution is made from a Traditional 401(k), the account holder is subject to taxation on both the contribution(s) and the earnings. Alternatively, the account holder is not subject to any taxation from Roth 401(k) distributions so long as they are qualified.
Roth 401(k) Strategy
The benefits of a Roth 401(k) have the most impact on individuals currently in low tax brackets that anticipate moving into higher tax brackets in the future. This is because contributions are taxed now at a lower tax rate and distributions are tax-free when the individual is in a higher tax bracket. For this reason, a Roth 401(k) is not advised for individuals expected to drop tax brackets (such as individuals close to retirement who will experience a drop in income).