What is a 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 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 on future withdrawals.


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 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 in 2019 is $19,000 per year (up by $500 from 2018). Individuals 50 and older can contribute an additional $6,000 in 2019 as a catch-up contribution, according to the IRS. 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 percent owner of the business sponsoring the plan.

Roth 401(k): Qualified Distributions

Contributions and earnings in a 401(k) are eligible to be withdrawn without an income tax assessment as long as certain criteria are met.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 59 ½ years old.

Key Takeaways

  • Roth 401(K) is a hybrid retirement savings vehicle that offers tax benefits by combining features from traditional 401(k) plans and Roth IRAs.
  • Contributions and earnings in a 401(k) are eligible to be withdrawn without an income tax assessment as long as certain criteria are met.

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 the contribution is deducted from the employee's pre-tax 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. Alternatively, the account holder is not subject to any taxation from Roth 401(k) distributions so long as they are qualified.

A Roth 401(k) Strategy

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. For this reason, a Roth 401(k) is not advised for individuals who expect to drop tax brackets, such as individuals close to retirement and expect a drop in income.

Roth 401(k) History and Future

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) IRA to increase tax-deductible contributions that people could make to their IRA account. 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 and were enacted as part of the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA 2001). Roth 401(k)s are not available in all company-sponsored retirement schemes, though when they are available and savers are aware of the them about 60% opt for it over a traditional 401(k). Millennials are more likely to contribute to a Roth 401(k) than GenXers or Baby Boomers by a wide margin.

Example of Roth 401(k)

Suppose you earn $4,000 per month and have set aside 5% as Roth 401(k) contribution. Then $200 is deducted from your salary each month after tax withholdings. This is as opposed to your 401(k) contribution, which is deducted with pre-tax dollars. At the age of 70.5 years, you will have to begin taking required minimum distributions from your account.