|
You might be using an unsupported or outdated browser. To get the best possible experience please use the latest version of Chrome, Firefox, Safari, or Microsoft Edge to view this website. |
A Roth 401(k) is a defined contribution retirement plan funded by after-tax dollars. The Roth 401(k) plan shares many similarities with the Traditional 401(k) plan, although the latter is funded with pre-tax dollars. A Roth 401(k) also shares its after-tax contributions approach with the Roth IRA plan. However, there are important differences you should understand between a Roth 401(k), a Traditional 401(k) and a Roth IRA. Let’s take a closer look at all the details.
Taxes and when you pay them are key to understanding the difference between a Roth 401(k) and a Traditional 401(k). You contribute to a Roth 401(k) after tax: Income tax is withheld from your paycheck, and then your Roth 401(k) contribution is deposited in your account. When you take qualified distributions in retirement, you pay no income tax on the withdrawals.
Contrast this treatment with a Traditional 401(k), where contributions are made pre-tax. The money deposited in your Traditional 401(k) account is deducted from your paycheck before income taxes are withheld from your pay. Pre-tax contributions to a Traditional 401(k) lower your taxable income, reducing the amount you pay in taxes today. When you take qualified distributions in retirement, you owe income tax on the withdrawals.
When to pay income taxes on your 401(k) retirement savings is a core consideration in deciding between a Roth vs Traditional 401(k). Ask yourself: When will you be in a higher income tax bracket: Today, when you’re making contributions—or years from now, when you withdraw money in retirement?
Another thing to keep in mind: If your employer offers matching 401(k) contributions, they must be deposited in a Traditional 401(k) account. Even if you’ve opted to contribute to a Roth 401(k), your employer’s matching contributions still are deposited in a separate Traditional 401(k) account. You’ll pay taxes on the distributions from the account funded by your employer’s match, even while your Roth distributions are tax-free.
Both Roth 401(k)s and Traditional 401(k)s have the same contribution limits: In 2020, employees age 50 or younger may contribute up to $19,500, with additional catch-up contributions of $6,500 available for savers who will be 50 by the end of the year.
These limits are cumulative: If you have more than one 401(k) account—for instance, both a Roth 401(k) and a Traditional 401(k), or 401(k) accounts with two employers after changing jobs—combined contributions to both accounts cannot exceed a total of $19,500, or $26,000 for those who are 50 or older.
The combined limit on employer matching contributions and employee contributions is $57,000 for 2020, or 100% of an employee’s compensation (up to a maximum of $285,000), whichever is lower. For employees over 50, the combined limit is $63,500—$57,000 plus the $6,500 catch-up contribution. To reach this limit, some plans permit employees to make non-Roth, after-tax contributions.
There are three types of withdrawals from a Roth 401(k): qualified distributions, hardship distributions, and non-qualified distributions. Each type has its own rules, pros and cons.
You can start making qualified distributions from a Roth 401(k) once you’ve satisfied two conditions: You’re age 59 ½ or older and you’ve met the five-year rule. This rule states that you must have made your first contribution to the account at least five years before making your first withdrawal. Note that if you retire and roll your Roth 401(k) balance into a Roth IRA that has been open for more than five years, the five year requirement is met.
For example, if you started contributing to a Roth 401(k) at age 58, you would have to wait until you were 63 to begin making qualified distributions.
There are a few other conditions that allow you to withdraw money from your Roth 401(k) due to hardship, depending on the rules of your plan. These include:
Additionally, if you die, the full amount in your Roth 401(k) can be distributed to your named beneficiaries without penalty.
You can withdraw funds from your Roth 401(k) early without meeting the conditions listed above—these withdrawals are non-qualified distributions. If you’re not 59 ½, or you haven’t waited five years after making your first contributions, or you don’t qualify for a hardship withdrawal, you may have to pay income taxes and a 10% IRS tax penalty on some—but not all—of the amount you take out.
Here’s the tricky part: Early withdrawals must include both contributions and earnings, prorated based on the ratio of contributions to earnings in the account. Consider a Roth 401(k) with a balance of $20,000—$16,000 of which are contributions and $4,000 of which are earnings. Any early withdrawal from this account would therefore comprise 80% contributions and 20% earnings.
If our theoretical account holder took an early withdrawal, the 80% portion of the withdrawal that came from contributions would be free of tax and not subject to the 10% penalty. But the 20% portion comprising earnings would be taxed as regular income, and subject to a 10% tax penalty.
These rules provide additional flexibility to withdraw money from your Roth 401(k) in times of need and possibly pay fewer penalties that you would for a similar early withdrawal from a Traditional 401(k). However, it’s not a good idea to give up your hard-earned retirement savings and earnings in tax penalty payments, and early withdrawals from retirement accounts should always come last in a long list of alternatives.
[Note: The CARES Act allows eligible 401(k) participants younger than age 59 ½ to take an early distribution of up to $100,000 during calendar year 2020 without paying the 10% tax penalty. Note that this is $100,000 in total, per person, no matter how many retirement accounts you have.]
Like a Traditional 401(k), you must begin taking required minimum distributions (RMDs) from your Roth 401(k) by April 1st of the year after you turn 72. The amount of your annual RMD is calculated based on your account balance and your life expectancy.
When figuring out a withdrawal schedule that’s best for you, it’s a good idea to consult with a financial advisor. They can help you figure out how to balance your various RMDs and withdrawal rates, as well as help you balance them with Social Security benefits.
If you’ve reached age 72, one way to avoid RMDs is by rolling over your Roth 401(k) into a Roth IRA. However, it’s important to note that when you roll over the funds into a newly opened Roth IRA, you may have to wait another five years before you can begin taking qualified withdrawals. If you roll the funds into an already-established Roth IRA that’s been around for at least five years, there’s no wait.
[Note: The CARES Act has suspended required minimum distributions for 2020.]
If your plan rules allow it, you can take out a loan from your Roth 401(k) account. The rules for 401(k) loans are fairly uniform once the funds are distributed, but it’s up to your employer to decide whether they want to offer this benefit or not. They also decide who qualifies for a 401(k) loan.
There are risks involved with 401(k) loans. If you are laid off or quit while your loan is outstanding, you will need to repay the loan by the time you file taxes the year after you left your job. Taking advantage of all the possible extensions would mean you have until October 15th of the next year to repay the loan. Otherwise, the outstanding loan balance is considered as a non-qualified early withdrawal, subject to the 10% tax penalty.
Both Roth 401(k)s and Roth IRAs are funded by after-tax contributions. And once you’ve owned either account type for at least five years, you’ll be able to start withdrawing money tax free after you turn 59 ½. But there are key differences between these two similarly named retirement accounts you need to know about: