How is a Roth 401(k) taxed? The essence is that it doesn't give you a tax deduction when you contribute like a standard 401(k). Instead, a Roth 401(k) is a type of employer-sponsored retirement plan that offers employees the ability to contribute after-tax dollars. The payoff: Withdrawals are tax free in retirement.

These plans have only been available since 2006, but they are gaining in popularity as more workers attempt to establish retirement income free from tax liability. 

Not all company-sponsored retirement schemes offer a Roth 401(k).But when they are available and savers are aware of them, 43% of employees opt for one over a traditional 401(k). Millennials are especially likely to contribute to a Roth 401(k).

Key Takeaways

  • The main advantage of a Roth 401(k) is that withdrawals are tax free in retirement.
  • Like other retirement accounts, distributions taken before age 59½ are subject to an early withdrawal penalty.
  • Roth 401(k) tax advantages can be particularly appealing to high earners.

Let's take a look at the tax nuances of Roth 401(k)s and how they differ from a traditional 401(k) and a Roth IRA.

A Closer Look at Taxes

Before you make the Roth 401(k) choice, consider the following tax consequences.

Tax deductions

Like other qualified retirement accounts, no tax is due for each year the funds are in the account. Also, since no deduction is given for contributions and no taxes are due for distributions in retirement, the only tax ramification for participating in a Roth 401(k) is losing the advantage of having the amount of your contribution deducted from your taxable income in the year that it is made. Lowering your taxable income is a key advantage of contributing to a regular 401(k). That aspect can be discussed with your tax advisor.

Contributions to a Roth 401(k) must be made before the end of the calendar year (Dec. 31), though any contributions made by an employer have until the employer's tax filing deadline.

Employer contributions

Though employee contributions are made with after-tax dollars, with the opportunity for earnings to grow tax free, no employer-match contributions can be allocated to the Roth portion of the account. Earnings grow tax free within the Roth 401(k), and no taxes are incurred upon distribution in retirement.

No income restrictions (unlike a Roth IRA)

A major tax advantage of a Roth 401(k) is the opportunity for higher-earning individuals to contribute more dollars into a retirement account that will be tax free at retirement. Higher income individuals do not qualify to open a Roth IRA, but they can contribute to a Roth 401(k).

For tax year 2019, the annual income limit for contributions to a Roth IRA is a modified adjusted gross income (MAGI) of $137,000 for singles with a phase-out starting at $122,000. For those married filing jointly, MAGI must be less than $203,000, with phase-outs starting at $193,000. Those figures are up a bit from tax year 2018, when the phase-out for singles started at $120,000 and maxed out at $135,000. For those married filing jointly, MAGI had to be less than $199,000, with reductions beginning at $189,000.

The Roth 401(k) has no such income restrictions. Contributions are, however, limited to $19,000 per year for tax year 2019 (up from $18,500 in 2018) with another $6,000 for participants over the age of 50 (up from $5,500 in 2018). These are the same amounts permitted for contributions to a regular 401(k).

RMDs: You Do Have to Take Them...

Distributions made prior to age 59½ are, like other retirement accounts, subject to an early withdrawal penalty. And there's a difference between how annual required minimum distributions (RMDs) are handled for a Roth 401(k) compared to a Roth IRA.

Roth IRAs do not mandate RMDs during the lifetime of the account holder. Roth 401(k)s do. The good news: The money is not taxable, unlike the money you take from a traditional 401(k). Even better, because Roth 401(k) distributions are not taxable, they have no impact on the taxability of your Social Security benefits. 

The bad news: Once you take a distribution from your Roth 401(k), that money cannot continue to grow tax free.

...But There's a Way Out

There is a good way around this, though. If you roll over your Roth 401(k) into a Roth IRA at retirement, you will no longer have the RMD requirement. And it is one way for high-income individuals to acquire a Roth IRA they otherwise would be too affluent to qualify to open.