The arena of employer-sponsored retirement plans has been dominated by 401(k) plans that are funded with pre-tax contributions, which effectively defers taxes until distributions begin. However, the Roth 401(k) is funded with after-tax money just like a Roth IRA, allowing retirees to enjoy qualified tax-free distributions once they reach age 59½ and have met the five-year holding requirement.
It might be smart to invest in a Roth 401(k) if you believe that you will be in a higher tax bracket during retirement. This is always a possibility, especially if you end up with fewer tax deductions during your post-working years. On the other hand, if you expect to be in a lower tax bracket during retirement, then deferring taxes by investing in a traditional 401(k) may be the answer for you. If you have not been able to contribute to a Roth IRA because of the income restrictions, you will be happy to know that there are no income limits with a Roth 401(k).
Employers may match employee contributions to a Roth 401(k) plan, but any matching contributions must go into a traditional 401(k) account. That is, employer contributions and any earnings are always made on a pre-tax basis and are taxable when distributed from the plan.
If an employer offers a Roth 401(k) plan, employees have the option of contributing to either the regular (pre-tax) or the Roth account, or even both at the same time. If you do not know which type of account would be better for your financial situation, you might split your contributions between the two types of plans. It’s important to note that your combined annual contributions to a 401(k) plan cannot exceed $19,500 if you are under age 50, or $26,000 if you are 50 or older (in 2020, up from a total of $25,000 in 2019). These amounts are indexed for inflation.
If your employer offers a Roth 401(k) plan and allows in-plan Roth conversions, you can make transfers of your pre-tax account and employer contribution account to a Roth 401(k) account at any time. Conversion is a taxable event. Funds converted are taxed as ordinary income in the year of the conversion.
Upon separation of service, you can roll over your Roth 401(k) assets to another Roth 401(k), a Roth 403(b), or a Roth IRA. Assets cannot be rolled over to a traditional 401(k) account. If you transition from an employer that offers a Roth 401(k) plan to an employer that does not, your only option would be to roll the assets directly to a Roth IRA or to leave your money in your former employer’s plan (if allowed).
The required minimum distribution guidelines of a Roth 401(k) work like those of traditional 401(k) plans. You must generally begin taking distributions after reaching age 72, either as a lump sum or on a required minimum distribution schedule based on your life expectancy. However, unlike traditional 401(k) withdrawals, qualified Roth distributions are free of federal income taxes.1
If you see the advantages of having tax-free income in retirement, then you might consider a Roth 401(k). It allows you to contribute more annually than you could to an IRA, and the tax-free distributions won’t add to your income tax liability. Of course, before taking any specific action, you might want to consult with your tax professional.
1Due to the Coronavirus Aid, Relief, and Economic Security (CARES) Act, required minimum distributions (RMDs) are waived in 2020.