What Is Roth 401(k)?

A Roth 401(k) is an employer-sponsored investment savings account that is funded with after-tax dollars up to the plan's contribution limit. This type of investment account is well-suited for people who think they will be in a higher tax bracket in retirement than they are now, as withdrawals are tax-free. The traditional 401(k) plan, by contrast, is funded with pretax money, which results in a tax on future withdrawals.

Key Takeaways

  • A Roth 401(K) is a tax-advantaged retirement savings vehicle that combines features from traditional 401(k) plans and Roth IRAs.
  • Roth 401(k) contributions and earnings can be withdrawn tax-free as long as certain criteria are met.
  • For 2020 and 2021, Roth 401(K) contribution limit is $19,500, and those 50 and over can contribute an additional $6,500.
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Introduction To The 401(K)

Understanding Roth 401(k)

A Roth 401(k) is a unique hybrid retirement savings vehicle that combines many of the best features of traditional 401(k) plans and Roth IRAs. Employee contributions are made using after-tax dollars within certain income limitations.

In 2001, Congress passed the Economic Growth and Tax Relief Reconciliation Act (EGTRRA). The act cut income tax rates following the 2001 recession and created the Roth 401(k) to increase tax-deductible contributions that people could make.

Since the beginning of 2006, employers have been allowed to amend their 401(k) plan documents so that employees can opt for Roth IRA tax treatment (contributing with after-tax dollars) for a portion or all of their retirement contributions. Roth 401(k)s are outlined in section 402A of the Internal Revenue Code.

A Roth 401(k) is subject to contribution limits based on the individual's age. For example, the contribution limit for individuals in 2020 and 2021 is $19,500 per year. Individuals 50 and older can contribute an additional $6,500 as a catch-up contribution.

Withdrawals of any contributions and earnings are not taxed as long as the withdrawal is a qualified distribution, which means certain criteria must be met. First, the Roth 401(k) account must have been held for at least five years. Additionally, the withdrawal must have occurred on the account of a disability, on or after the death of an account owner, or when an account holder reaches at least age 59½.

Distributions are required for those at least 72 years old (70½ before January 1, 2020) unless the individual is still employed at the company that holds the 401(k) and is not a 5% (or more) owner of the business sponsoring the plan.

Suppose you earn $4,000 per month and have set aside 5% as a Roth 401(k) contribution. Then $200 is deducted from your salary each month after tax withholdings. This is as opposed to a 401(k) contribution, which is deducted from pretax dollars.

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 contribution is deducted from the employee's pretax income. Alternatively, contributions made to a Roth 401(k) are made after taxes are already taken out.

When a distribution is made from a traditional 401(k), the account holder is subject to taxation on the contributions and its earnings. But with a Roth 401(k), the account holder is not subject to any taxes from distributions so long as they are qualified.

Roth 401(k)s are not available in all company-sponsored retirement schemes. When they are, 43% of savers opt for one over a traditional 401(k). Millennials are more likely to contribute to a Roth 401(k) than Gen Xers or baby boomers.

Unlike a Roth 401(k), a Roth IRA is not subject to required minimum distributions.

Roth 401(k) Advantages

The benefits of a Roth 401(k) have the most impact on individuals currently in low tax brackets who 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. Younger individuals also have more time for the account to grow tax-free before retirement and, thus, to benefit more from the fact that distributions of not just contributions but earnings are not taxed.

That's why a Roth 401(k) may be less beneficial to those who expect to drop tax brackets, such as individuals close to retirement who expect a drop in income.

Frequently Asked Questions

How Does a Roth 401(k) Differ from a 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 contribution is deducted from the employee's pretax income. Alternatively, contributions made to a Roth 401(k) are made after taxes are already taken out. When a distribution is made from a traditional 401(k), the account holder is subject to taxation on the contributions and its earnings. But with a Roth 401(k), the account holder is not subject to any taxes from distributions so long as they are qualified.

Who Benefits the Most from a Roth 401(k)?

Individuals currently in low tax brackets who anticipate moving into higher tax brackets in the future will benefit the most from a Roth 401(k). 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. Younger individuals also have more time for the account to grow. The distributions, including the earnings, are tax-free provided some basic criteria are met.  Millennials are more likely to contribute to a Roth 401(k) than Gen Xers or baby boomers.

What Are the Criteria for Roth 401(k) Withdrawals?

Withdrawals of any contributions and earnings are not taxed as long as the withdrawal is a qualified distribution, which means certain criteria must be met. First, the Roth 401(k) account must have been held for at least five years. Additionally, the withdrawal must have occurred due to a disability, after the death of an account owner, or when an account holder reaches age 59½. Distributions are required for those at least 72 years old (70½ before January 1, 2020) unless the individual is still employed at the company that holds the 401(k) and is not a 5% (or more) owner of the business sponsoring the plan.