Roth 401k: Introduction
AS THE NAME suggests, a Roth 401(k) combines features of the traditional 401(k) with those of the Roth IRA. It's offered by employers like a regular 401(k) plan, but as
with a Roth IRA, contributions are made with after-tax dollars. While you don't get an upfront tax-deduction, the account grows tax-free, and withdrawals taken during
retirement aren't subject to income tax, provided you're at least 59 1/2 and you've held the account for five years or more.
The Roth 401(k) can offer advantages to high-income individuals who haven't been able to contribute to a Roth IRA because of the income restrictions. (Eligibility for 2009
phases out between $105,000 and $120,000 for single filers and $166,000 to $176,000 for those who are married and file jointly).
In addition, Roth 401(k) accounts are subject to the contribution limits of regular 401(k)s — $16,500 for 2009, or $22,000 for those 50 or older by the end of the year —
allowing individuals to stock away thousands of dollars more in tax-free retirement income than they would through a Roth IRA. (In 2009, Roth IRA contributions are limited
to $5,000 a year, or $6,000 for those 50 or older.)
The hitch: Those limits apply to contributions to both types of 401(k) plans, so you can't save $16,500 in a regular 401(k) and another $16,500 in a Roth 401(k). Workers who
are offered this option face a difficult choice: Contribute to a Roth 401(k) and suffer a cut in take-home pay (since contributions are made with after-tax dollars), or stick with a traditional 401(k) and hope that in retirement, their tax rate will be lower than it is now. Alternatively, they could hedge their bets by contributing to both accounts.
If you expect your tax rate to be the same or higher in retirement than it is now, you might be better off with a Roth 401(k). This is likely to be the case with young people who are just
starting their careers and expect their income to increase in the future. If you're in your peak earning years, on the other hand, and you figure your tax bracket will be lower in retirement, you'll benefit from continuing with traditional 401(k) contributions.
In reality, of course, things are much more complicated. For one, no one can predict with certainty what tax rates will be in the future, though the general consensus is that they're likely to rise to help the government offset growing budget deficits and pay for Social Security and Medicare.
Roth 401(k): Quick Overview
In deciding whether to make traditional 401(k) or Roth 401(k) contributions, your first consideration may be your expectation of your future tax rates. However, there are several other personal considerations. We've already mentioned one very important one, making sure you take full advantage of your employer's matching contribution, if available.
Qualifying for tax-free Roth 401(k) distributions there are two requirements to take a tax-free distribution, otherwise known as a "qualified distribution," from a Roth 401(k):
At least five years must elapse from the year of your initial contribution, and you must have reached age 591/2 or become disabled or deceased. If you take a non-qualified distribution, any investment returns are subject to regular income tax, plus a 10% tax penalty before age 591/2. Because your contributions are made with after-tax income, they will not be subject to taxes. Keep these requirements in mind if you are planning to take a distribution from your Roth 401(k).
In addition, traditional 401(k) and Roth 401(k) balances are subject to minimum required distributions by April 1 of the year following the year in which you reach age 701/2 or at retirement, if later. However, with a Roth 401(k) you can roll eligible amounts to a Roth IRA, which is not subject to the lifetime minimum distribution rules. Other distribution requirements may apply after your death.
Roth 401(k): Frequency Asked Questions
1. Who is eligible for a Roth 401(k)?
Anyone whose employer offers it. This is where it gets tricky: Among the major concerns for employers are the costs associated with managing the plan, and educating their workforce about this investment option. According to the PSCA's Wray, companies are much more likely to offer a Roth 401(k) if their employees indicate that they intend to participate. So if you want a Roth 401(k) option to be added to your plan, make sure to let your employer know.
2. What happens to the employer match?
Employer matches are made with pretax dollars, and the match accumulates in a separate account that is taxed as ordinary income at withdrawal.
3. What are the early withdrawal rules?
Early Roth 401(k) withdrawal rules are subject to the same requirements as traditional 401(k) s, according to the IRS. If your company rolls out a Roth 401(k) next year, be sure to ask your plan manager.
4. What happens if I leave my job?
The Roth 401(k) balance can be rolled over into a Roth IRA.
5. Is the Roth 401(k) option here to stay?
Yes. At one time, the Roth 401(k) option was set to expire after 2010, but it was made permanent by 2006 legislation. So this is a deal you can count on
*Benefit, right or feature
Contributing to a Roth 401k Account
|401(k) Pretax Contribution||Roth 401(k) Contribution||After-Tax Contribution
|Taxation of Contributions||Not taxed||Taxed||Taxed
|Taxation of Distributions||Entire distribution is taxable||"Qualified" distributions are tax free||Contributions are distributed tax free; earnings are taxable
|Vesting||100% immediate||100% immediate||100% immediate
|Availability||Right to each rate of contributions is a BRF*||Right to Roth contributions is a BRF||Right to each rate of contributions is a BRF
|Subject to 402(g) Limitations||Aggregated with Roth 401(k)||Aggregated with 401(k)||No
|Nondiscrimination Testing||ADP: Aggregated with Roth 401(k)||ADP: Aggregated with 401(k)||ACP
|Loans and Hardship Withdrawals||Yes||Yes||Yes
|Other In-Service Distributions||Not before 59 ½||Not before 59 ½||Yes
|Distributions at Separation From Service||Yes||Yes, but tax advantage lost unless after 59 ½||Yes
|10% Early Distribution Penalty||Yes||Yes, to the extent taxable||Yes, to the extent taxable
|Eligibility for Rollover||Yes||Yes, to Roth IRA or another Roth account||Yes
Let's walk through an example.
How will life be different if you contribute to a Roth 401k account instead of a traditional 401(k) account? The easiest way to see is to walk through an example. Let's say you're in the following situation:
- You earn wages of $60,000.
- You're in the 25% tax bracket.
- You plan to contribute $6,000 ($500 per month).
- Your company matches your first $4,000 of contributions at 50 cents on the dollar.
First we'll see what happens if the money goes into a traditional account, and then we'll see what changes if you choose a Roth account instead.
If your contributions go to a traditional account, you still pay Social Security tax on the full $60,000 of earnings, but you pay income tax on only $54,000. In the 25% tax bracket the $6,000 reduction in your taxable income saves you $1,500.
That $1,500 in tax savings isn't likely to come to you in the form of a big refund. It normally shows up mainly as a reduction in the amount of income tax withholding taken from your paycheck, although the change in withholding isn't necessarily precisely the same as the actual tax savings. You may not even notice that you're receiving a tax benefit because it has little effect on the amount of tax you owe at the end of the year (or the size of your refund), but it's there in the form of a net paycheck that's about $125 per month bigger than it would be without the tax savings.
Meanwhile, you end up adding $8,000 to your traditional 401k account: $6,000 from your contributions and $2,000 from the company's matching contribution. Eventually you'll have to pay tax on your distributions from that account, including all the earnings that build up over the years.
If your contributions go to a Roth account, you pay Social Security tax and income tax on the full amount. Again you should understand that the tax difference doesn't usually show up in a lump at the end of the year. The difference normally shows up in the amount of withholding from your paycheck. The difference is that your net pay didn't get the $125 per month boost you would have received from contributing to a traditional account.
You end up adding $6,000 to your Roth account and $2,000 to your traditional account. (The rules say the matching contribution has to go to a traditional account, not a Roth account.) The total amount added to your retirement savings is the same, but $6,000 is in an account where all your withdrawals, including any earnings that build up in that account over the years, will be tax free if you follow the rules. Contributions to a Roth account squeeze your budget somewhat more than if you put the same amount in a traditional account. The payoff comes from having a lot more wealth in retirement because distributions from this account will be tax-free
Five-Year Requirement for Roth 401k
This is one of the tests to take qualified distributions from a Roth 401k account.
One of the tests for a qualified distribution is the five-year requirement. If you don't meet this test, you'll have to pay tax on the earnings portion of any distribution that isn't rolled over. Remember, this is only one of the tests for a qualified distribution. You also have to be over 59½ or disabled.
When the clock starts
The clock starts on your five-year period the first day of the first year for which you make a Roth 401k or 403b contribution. That's true even if you didn't make any contributions until December. For example, if you started to make Roth 401k contributions at any time in 2006, your clock starts on January 1, 2006 and you'll complete your five years at the end of 2010. Beginning January 1, 2011 you can take qualified distributions if you're over 59½ or disabled.
Suppose you started your Roth 401k contributions in December and the money didn't actually go into your account until January. (There's often a small time lag between the date of your paycheck and the date the money goes into the account.) No problem: the regulations say this contribution counts for the previous year, because that is the year you had to report the income from that paycheck.
Different accounts, different clocks
In the world of Roth IRAs you have just one five-year clock for all your accounts (except for a special rule that applies to conversions). That isn't true for Roth 401k accounts. If you start an account with one employer in 2006 and start an account with a different employer in 2008, you have to deal with two different five-year periods. Assuming you're over 59½ or disabled, you can take qualified distributions from the first account beginning in 2011, but you'll have to wait until 2013 to take qualified distributions from the second account.
There's an exception if you roll the first account over to the second account. In this case, the entire account is treated as if it started in the earliest year of either of the two accounts.
Account age doesn't roll over
The age of your Roth 401k account doesn't transfer to a Roth IRA when you do a rollover. This peculiar rule can work to your advantage or disadvantage.
- Suppose you've had a Roth 401k for just a few years, but you've had a Roth IRA more than five years. In this case, you can satisfy the five-year test for all your money by rolling the Roth 401k to a Roth IRA.
- The reverse situation is more awkward. You might have held your Roth 401k account several years without holding a Roth IRA. When you create a Roth IRA to receive the rollover from the Roth 401k, you'll start a new five-year waiting period before you can take qualified distributions.
For most people this won't be a problem, because you don't have to pay tax on your Roth IRA distributions until you've withdrawn your entire basis
Distributions from Roth 401k/403b Accounts
They're similar to Roth IRA distributions, but with some important differences.
The main rules for taking distributions from Roth 401k or 403b accounts are similar to the rules for Roth IRAs, but with a few differences.
Access to the money
This is one area where 401k and 403b accounts differ from IRAs. If you want to take money from your Roth IRA, all you have to do is contact the financial institution and tell them to send the money (selling assets for that purpose, if necessary). In this area, a Roth 401k account works the same as a traditional 401k account. You can take the money any time you want after termination of employment, but prior to termination you usually can't take money out of your account unless you qualify for a hardship distribution. You have the same access to your Roth 401k account as your traditional 401k account: no more, no less.
Choice of account
If you have both traditional and Roth accounts in the same 401k or 403b plan and you make a partial withdrawal, you should be able to choose which account the money is coming from. This choice may be useful for tax planning in general and also for avoiding nonqualifying distributions from the Roth 401k or 403b account, as described below.
Unless you're rolling your money to another Roth account (a Roth IRA or a Roth account in another employer's plan), you'll want your distributions to qualify for tax-free treatment. The rules here are similar to the Roth IRA rules. You need to have the account five years and in addition you have to be 59½ or disabled. (Distributions after your death can qualify also.)
The Roth IRA rule for first-time homebuyers does not apply to a Roth 401k account. There's one difference you'll want to note if you work for more than one company that offers these accounts. The five-year rule applies to each employer's 401k separately, except you get credit for prior years if you roll money from one plan to another.
Example: Your first Roth 401k contribution at one employer was in 2006. In 2008 you changed jobs and began contributing to the Roth 401k at a second employer. Assuming you're over 59½, you can begin to take qualifying distributions from the first account in 2011, but you have to wait until 2013 to take qualifying distributions from the second account. If you roll the money from the first account to the second one, though, the combined account is treated as one that was started in 2006.
This is different from the rule for Roth IRAs, where new accounts acquire the "aging" of earlier accounts without the need for a rollover.
If you don't meet the requirements described above, and you take money out of your Roth 401k or 403b account without rolling it to another Roth account, you'll have a nonqualifying distribution. When you take nonqualifying distributions from a Roth IRA, your distributions are tax-free until you've withdrawn all your contributions. According to the Treasury, a Roth 401k account doesn't work that way. When you take a nonqualified distribution from this account, you have to report taxable income in proportion to the account's earnings when you take a distribution. For example, if 80% of the money in the account is from your contributions and another 20% is from earnings, your distribution will be 20% taxable even if the amount you withdraw is less than the amount of your contributions.
This rule looks only at the account from which you took the distribution. Some of the rules for IRAs say you have to add all your accounts together to figure the ratio between contributions and earnings, but those rules don't apply here.