What Is a Roth Option?
A Roth option is an option to invest retirement savings in a special Roth account and is available in some public and private retirement benefit plans. It may also be available through small business retirement plans. A Roth option allows an employee to contribute after-tax dollars to a special Roth account that usually reaps all of the advantages that individual Roth IRAs have to offer.
- A Roth option is an option to invest retirement savings in a special Roth account.
- Roth contributions are made from after-tax income at the current tax rate.
- A withdrawal of Roth contributions and earnings may be taken tax-free provided that it's a qualified distribution and that the account has been held for at least five years.
- A qualified distribution, as defined by the Internal Revenue Service, includes distributions taken as a result of disability, on or after death, and on or after turning 59½.
Understanding a Roth Option
A Roth option is an iteration of the Roth IRA, offered especially for employees through a retirement plan package. A Roth option is created with the same characteristics as a Roth IRA. Money is contributed after-tax. The accumulated funds are not subject to any further taxes after being invested. This means all withdrawals in retirement are tax-free.
One special advantage of most Roth accounts is that contributions can be withdrawn prior to age 59½, without the 10% early withdrawal penalty, if the account has been open for five years and the withdrawal constitutes what the Internal Revenue Service calls a qualified distribution. Qualified distributions include withdrawals on account of disability or withdrawals on or after death.
On the other hand, a traditional 401(k) plan or traditional IRA offer immediate tax savings. The money paid in is subtracted from the employee's taxable income for that year. For after-tax contributors to a traditional IRA or other tax-advantaged retirement accounts, those contributions can be taken as a lump sum deduction for the year. Taxes are therefore required when the person withdraws funds after retiring. Traditional IRAs and IRA options also generally have a 10% early withdrawal penalty if any funds are taken out before the age of 59½.
Who Needs a Roth Option?
A Roth option can be a good choice for a few reasons. Mainly, it is best for investors who may want to draw on the account as an emergency fund sometime in the future. It can also be optimal for investors who think they will be in a higher tax bracket in retirement, though this is usually not the case for most people.
A Roth option is typically matched by an employer in the same way that a traditional 401(k) is matched. A Roth option can be optimal for people who want to contribute savings to a fund that may be used for emergencies if they arise. Roth options usually have the same liquidity feature as Roth IRAs; contributions can be withdrawn without penalty after five years provided the withdrawal is a qualified distribution. This means an investor could potentially draw on the contributions far earlier than the age 59½ threshold, without paying either a 10% early withdrawal penalty or taxes, provided the withdrawal is a qualified distribution.
For those investors who are secure in their financial planning, the Roth option is not necessarily superior theoretically (especially if matching is offered in both traditional and Roth options). With the Roth option, investors contribute funds with after-tax dollars. This means funds are taken from an employee’s wages after taxes have been applied, not before. This results in the current tax rate being paid on income rather than the applicable tax rate in retirement, which is usually lower.
For most people, deferring taxes until retirement is optimal because after leaving a job, many people live on their retirement savings as income, and that is usually equal to or less than their regular earnings, often putting them in a lower bracket. In retirement, investors may also have the option to withdraw funds at will rather than getting a steady paycheck, which can make income lumpy but also more eligible for lower tax rates.
Ultimately, the decision between a Roth option versus a tax-deferred option can be somewhat marginal. For many people, the advantage of accessing emergency funds as a qualified distribution after five years may outweigh any tax-advantaged benefit from deferring to a lower tax rate in the future.
However, as you can see from the information below, it can be wise to view the government’s tax brackets when making this decision.
Given tax rates in 2022, a single taxpayer who believes they might move from the 22% tax bracket down to the 12% tax bracket in retirement would be the most vulnerable since the tax rate differential is 10%. This person would probably much rather pay a tax rate of 12% in retirement than 22% at the current rate if they can afford to wait until those funds are available without penalty after age 59½.
For 2022, the tax brackets are as follows:
- 37% for incomes over $539,900 ($647,850 for married couples filing jointly)
- 35% for incomes over $215,950 ($431,900 for married couples filing jointly)
- 32% for incomes over $170,050 ($340,100 for married couples filing jointly)
- 24% for incomes over $89,075 ($178,150 for married couples filing jointly)
- 22% for incomes over $41,775 ($83,550 for married couples filing jointly)
- 12% for incomes over $10,275 ($20,550 for married couples filing jointly)
- The lowest rate is 10% for incomes of single individuals with incomes of $10,275 or less ($20,550 for married couples filing jointly).
For 2023, the tax brackets are as follows:
- 37% for incomes over $578,125 ($693,750 for married couples filing jointly)
- 35% for incomes over $231,250 ($462,500 for married couples filing jointly)
- 32% for incomes over $182,100 ($364,200 for married couples filing jointly)
- 24% for incomes over $95,375 ($190,750 for married couples filing jointly)
- 22% for incomes over $44,725 ($89,450 for married couples filing jointly)
- 12% for incomes over $11,000 ($22,000 for married couples filing jointly)
- The lowest rate is 10% for incomes of single individuals with incomes of $11,000 or less ($22,000 for married couples filing jointly).
IRS Rules for Retirement Investing
The IRS has a variety of rules for retirement investing. Namely, limits on the amount an investor can invest in different types of retirement vehicles. The IRS’s limits on allowable retirement investments by vehicle each year can influence investing decisions. They may also lead to splitting contributions between the pre-tax and after-tax versions, providing for the best features of both accounts.
For tax year 2022, individuals can contribute $6,000 to an IRA account with a $1,000 catch-up contribution allowed for those 50 and older. This limit applies to any type of IRA account (meaning $6,000 is the maximum contribution allowed to all IRA accounts comprehensively). The contribution limit rises to $6,500 in 2023, with the catch-up contribution amount holding steady at $1,000.
A Roth option may or may not be considered an IRA depending on how it is customized by an employer. The Roth 401(k) is subject to the 401(k) investing limits, which are much higher. For the tax year 2022, employees can contribute $20,500 to a 401(k), 403(b), 457 plan, and the federal government's Thrift Savings Plan (rising to $22,500 in 2023). People age 50 and above can contribute up to $6,500 more as a "catch-up contribution" for 2022 (rising to $7,500 in 2023).
Different Types of Roth Options
The Roth 401(k) option is one of the most popular Roth options. Roth options can also be offered in public 403(b) plans and used by small business owners.
403(b) Roth options typically work in the same way as Roth 401(k)s. Small businesses can offer a variety of Roth options with their benefit plans, many of which may be considered Roth IRA accounts.
Small business Roth options vary more widely because of the many different options employers have, such as Simplified Employee Pension (SEP) and Savings Incentive Match Plan for Employees of Small Employers (SIMPLE) plans. Within the small business realm, self-employed workers can also potentially take advantage of Roth options through an individual Roth 401(k).