Consider saving after-tax income in a Roth 401(k) Plan
Tax-postponed income and earnings vs. tax-free earnings
A 401(k) plan allows plan participants to defer a portion of their current income to the plan. These deferrals, known as "pre-tax" deferrals, are excluded from taxable income when deferred, but are taxed, along with earnings, when distributed from the plan (unless the plan participant rolls the withdrawal into an IRA). Overall, with a 401(k) plan, tax on the deferrals and earnings is postponed until the funds are distributed.
Roth 401(k) plan deferrals are made from "after-tax" income. However, there is no taxation of the earnings attributable to the Roth deferrals when a "qualified" distribution of the Roth earnings is made from the plan. The result is that a distribution of the Roth earnings may be tax-free, rather than tax-postponed.
Timing of distributions of Roth deferrals and earnings
Because Roth deferrals are treated in the same manner as regular 401(k) plan deferrals, the same distribution restrictions apply. In general, a distribution may only be made upon a hardship, the attainment of age 59-1⁄2, death, disability, or termination of employment.
Potential tax planning strategy: Roth 401(k) deferrals may postpone, but not entirely avoid, Required Minimum Distributions (RMDs), if the Roth 401(k) deferral account is directly rolled to a Roth IRA account. This direct rollover to an IRA/Roth account should be executed before the Roth 401(k) account is subject to the normal RMD rules. Once in the Roth IRA account, these Roth IRA funds are not subject to RMD distribution requirements until the death of the IRA owner. This makes Roth 401(k)/Roth IRA assets of special use in estate planning. Please consult your income tax adviser for specific details.
A "qualified" distribution
In order to avoid the taxation of earnings attributable to Roth deferrals, a distribution from the plan must be a "qualified" distribution. A "qualified" distribution is one that is made after the participant attains age 59-1⁄2, becomes disabled, or dies. In addition, a "qualified" distribution occurs only if the distribution is made after the end of the five-year period beginning with the calendar year in which the participant first made a Roth deferral to the 401(k) plan (or to a prior plan if there is a rollover of Roth deferrals from the prior plan to the 401(k) plan).
If a distribution is not “qualified,” then the portion of the distribution in excess of the participant’s Roth deferrals is taxable. In addition, if a distribution is not “qualified,” then the distribution of these taxable earnings may be subject to a 10% premature distribution penalty tax.
Plan participant considerations
- Depending on whether an employer offers a traditional 401(k) and a Roth 401(k), the participant might need to choose how to split deferrals between pre-tax and post-tax income.
- Participants should consult the plan’s financial advisor for information on investments and factors to consider in deciding which type of deferral is right for them and their particular situation.
- Participants who think their tax rate might be higher in retirement might want to consider making Roth 401(k) deferrals.
- Participants who think their tax rate will be lower in retirement might want to continue making deferrals on a pre-tax basis.
A comparison of a Traditional 401(k) and a Roth 401(k)
|Benefit||Traditional 401(k)||Roth 401(k)|
|Maximum total annual contributions to the plan?2||$19,000 (in 2019)||$19,000 (in 2019)|
|Catch-up contributions?3||Yes; $6,000 a year maximum (in 2019)||Yes; $6,000 a year maximum (in 2019)|
|Income limits for high earners?4||No||No|
Required Minimum Distributions (RMDs) apply to Traditional 401(k) funds, but there is a planning strategy open to a Roth 401(k) account. Please see tax planning strategy above.
- 1Tax law requirements must be met. To qualify, withdrawals must be taken more than five years after the first Roth contribution is made and after age 59-1/2 or upon death or disability.
- 2Traditional and Roth 401(k) contributions are combined in applying maximum plan contribution.
- 3Traditional and Roth 401(k) catch-up contributions are combined in applying maximum plan catch-up limit.
- 4Unlike with Roth IRAs, there is no income limit on who can contribute to a Roth 401(k). However, both traditional and Roth 401(k) contributions may be limited by a plan’s nondiscrimination rules.