Roth 401(k) is something that you may already know about or have been hearing a lot more about lately. There are many retirement plan options available for employees. One of these options available to many employees is a Roth 401(k). More employers are now offering this option to their employees and it may be a valuable option for you. In this article, we will explore Roth 401(k) in-depth so you can decide if it’s the right retirement savings plan for you.
What is a Roth 401(k)?
A Roth 401(k) is a type of retirement plan that is offered through your employer. It combines some of the advantages of the Roth IRA and 401(k). The money you invest in your Roth 401(k) will grow without being taxed. You can choose how much you want to contribute each pay period from your after-tax income. The money you contribute to your Roth 401(k) will then be put into investment funds that consist of bonds, stock, and other assets.
Many employers offer a contribution match to the employee’s 401(k). One thing to keep in mind is that while your Roth contributions grow tax-free, the matching employer contributions are tax-deferred. Therefore, when you retire and take out the matching employer contributions, they will be taxed.
Who qualifies for Roth 401(k)?
Roth 401(k) is available to any employee who is eligible to contribute to a traditional account, a Roth account, or both. This option is only available through employers that offer Roth 401(k). There are no income restrictions to be eligible.
What are the benefits of a Roth 401(k)?
With a Roth account, you have already paid income tax on your contributions. You will not have to pay taxes on those again. In addition, you will not pay taxes on the growth of a Roth account as long as you follow the Qualified Distribution rules.
With a traditional account, you will pay income taxes not only on your contributions to the account but also on the growth. These taxes are paid when you withdraw the money, at the tax bracket you are in the year of withdrawal. So while you do get to lower your taxable income now, you may end up paying higher taxes on the withdrawals later.
Roth 401(k) vs Traditional 401(k)
The major difference between Roth 401(k) vs Traditional 401(k) is the timing of taxes. There are also many similarities between Roth 401(k) and Traditional 401(k). In fact, you may have both of these account types and may be able to contribute to both at the same time. Let’s break down the similarities and differences.
The main difference between these accounts is when you pay taxes. Roth accounts grow tax-free because you pay your income taxes before contributing the money. Traditional 401(k) accounts grow tax-deferred.
Tax-deferred means that your contributions into these accounts lower your current taxable income today. The contributions into your traditional 401(k) then grow tax deferred, meaning you won’t pay taxes on them or the growth until you withdraw the money. For example, let’s say your annual salary is $100,000. This is your gross income. If you choose to contribute 10% ($10,000) to a traditional 401(k), your taxable income now drops to $90,000 for this tax year. You took that 10% and deferred paying taxes on it. That $10,000 will now grow tax-deferred inside of your traditional 401(k). The amount of growth will depend on your investment choices as well as on market conditions. When you withdraw the money from your traditional 401(k) at retirement, the total withdrawals will be taxed.
With a Roth 401(k), you are paying your income taxes as normal, and then the money goes into your Roth 401(k) account. So with that same $100,000 of gross income, if you choose to contribute 10% to your Roth 401(k), you will pay income taxes on your full $100,000 (ignoring any other pre-tax deductions you may have). After income taxes are deducted, your contribution (still $10,000 for the year), goes into your Roth 401(k). When you withdraw the money from your Roth 401(k) at retirement, you can take both the contributions and earnings out tax-free!
Early withdrawals from a Roth 401(k) are pro-rated. A portion of your early withdrawal will be a tax-free return of contributions, and the other portion will be an early withdrawal of the growth.
Early withdrawals of a traditional 401(k) will usually incur a 10% penalty and income tax on the full withdrawal, regardless of how much you have contributed. This is because none of the money in this account has been taxed.
Contribution Limits 2023
The contribution limit for these two accounts is the same. It is $22,500 for 2023 which is up $2,000 from 2022. You can defer $22,500 out of your paycheck into a traditional 401(k). Alternatively, you can contribute $22,500 to your Roth 401(k). But can you contribute to both a Roth 401(k) and a traditional 401(k)? The answer is yes; however, the combined contribution limit for both accounts is $22,500. As long as the total amount of contributions between these two types of accounts does not exceed $22,500, you are able to have both types of tax treatment.
Make sure you don’t make these 401(k) mistakes!
Roth IRA vs. Roth 401(k)
What about a Roth IRA? How does this differ from a Roth 401(k)? Let’s take a look.
Roth IRA’s have income limits. If you make too much money, you are not eligible to contribute to a Roth IRA. Those limits are $153,000 Modified Adjusted Gross Income (MAGI) for single filers and $228,000 MAGI for Married Filing Jointly.
Roth 401(k) does not have income limits. Regardless of how much you make, if your company offers a Roth 401(k) option, you can participate. This difference allows higher-income earners to have tax-free retirement savings as well.
Roth IRA has a maximum yearly contribution limit of $6,500 with an additional $1000 catch-up contribution ($7,500 total) if you’re over age 50.
Roth 401(k) contribution limit is $22,500 with an additional $7,500 catch-up contribution ($30,000 total) if you’re over age 50. This is an obvious and huge benefit to a Roth 401(k). Prior to 2001, Roth 401(k)s did not exist. The maximum amount anyone could put into a Roth account was the yearly maximum for Roth IRAs.
Required Minimum Distributions (RMDs)
Roth IRAs do not have RMDs. You can leave this money growing tax-free for as long as you wish.
Roth 401(k)s do have RMDs starting at age 70.5 or age 72, depending on your birth year. However, starting in 2024, investors with Roth 401(k)s will no longer have to take RMDs.
Early Withdrawals out of a Roth 401(k): If your employer allows for in-service withdrawals, you can access your contributions tax and penalty-free, since they are made with money that has already been taxed. If you take the earnings out though, you may have to pay income tax as well as a 10% penalty. The problem with taking money from a Roth 401(k) before you meet the qualified distribution rules is that early withdrawals are pro-rated and will be considered partially your contributions and partially your earnings. You can’t choose to just take out earnings.
Early withdrawals from a Roth IRA allow you to take out your contributions anytime with no penalty and no tax.
Roth 401(k) limits
The 2023 contribution limits for a Roth 401(k) or traditional 401(k), or a mixture of both, is $22,500 if you are under 50. If you are age 50 or older, you can add in an additional $7,500 catch-up contribution for 2021.
Do employer contributions count against this $20,500 limit? The answer is no. You can put $22,500 out of your paycheck into either your Roth or traditional 401(k). It’s important to note that the above limits apply to all of your 401(k). If you have both a traditional and a Roth 401(k), you can only contribute $22,500 in total. However, you can decide how you would like to split the money between both accounts. Your employer can also add their contribution to your account. Remember, the employer contribution will be treated as traditional money and grow tax-deferred.
There is an annual maximum contribution limit for 401(k) accounts. Total combined contributions (employee and employer contributions combined) cannot exceed $66,000 for people under 50 and $73,500 for people over age 50 in 2023.
Solo Roth 401(k)
What if you’re self-employed and want to start contributing more to your retirement? If you are the only employee in your business, you can start a solo 401(k), also known as a one-participant 401(k) Plan.
Where does Roth come into this solo 401(k)? Well, as the employee, you can elect to make your deferrals into the plan Roth deferrals. They will then grow tax-free. As the employer, however, your contributions into the account will be traditional, or tax-deferred. So, much like a 401(k) through a company you might work for, a solo 401(k) would also have both types of tax treatment in your account.
Backdoor Roth IRA vs Mega Backdoor Roth IRA
The backdoor Roth IRA allows people with a higher income to make Roth contributions by making a traditional IRA contribution and then converting it to a Roth IRA. You pay the taxes on that money straight away. Your investments then grow tax-free and you can make tax-free withdrawals later. It’s completely legal and very simple! We discuss the steps to create a Backdoor Roth IRA here.
A mega-backdoor Roth IRA is a way for people with large amounts of excess funds that they would like to put away for retirement in a Roth IRA account. As discussed before, the yearly maximum contribution to a Roth IRA is $6,500 for people under age 50. There are also the income limits discussed before to consider. And, as we know, there is also a limit to the amount of 401(k) money people can defer ($22,500 for people under 50).
So what happens when someone wants to put more money aside and avoid potential capital gains taxes when they withdraw that money? Enter Mega Backdoor Roth IRA.
How does a Roth 401(k) affect my paycheck?
The contributions will be deducted from your paycheck after federal and state taxes are calculated. It’s important to understand that so you can calculate how much your take-home pay will be once taxes and your Roth 401(k) contributions have been deducted.
What happens to a Roth 401(k) when you leave your employer?
This is a common question. With so many people moving employers throughout their career, it is common for people to have multiple employer-sponsored retirement plans floating around. There are options when you leave an employer.
Do employers match Roth 401(k)s?
Some employers will match your Roth 401(k) contributions. It is important that you talk to your current or future employer to find out if they offer the Roth 401(k) employer match. However, keep in mind that the employer contributions will be made without any taxes having been paid on them, they are tax-deferred. This means that you will have to pay income taxes on the match and any growth associated with the match when you withdraw the money during retirement.
How much should I contribute?
Most experts recommend saving 10% to 15% of your income. We suggest that you use a retirement calculator (link) to help ensure that you meet your retirement goals. There are many factors that should come into play when you think about how much you should contribute to a 401k. Some of these include how much of your pay you can set aside, your age, how close you are to retirement, and the contribution limits for that year. If you are fortunate enough to have an employer that offers the 401(k) contribution match then this is something to consider as well. Talking to a financial planner can help you determine how much you should contribute to your 401(k) that will be most beneficial for you now and in the future.
Can you have a Roth IRA and a 401(k)?
As long as you are eligible to contribute to a Roth IRA, you can have both a Roth 401(k) and Roth IRA. You can max them to both accounts ($6,500 for Roth IRA and $22,500 for Roth 401(k) for those under age 50). This is potentially a lot of tax-free growth in a retirement account if you have access to a Roth 401(k) and are eligible for a Roth IRA!
What are the Roth 401(k) Withdrawal Rules?
It is important to know the withdrawal rules, otherwise, you will risk losing part of your savings to penalties and tax payments. To withdraw money from a Roth 401(k) tax-free, you need to follow the IRS rules for Qualified Distributions. A qualified distribution is one that is made at least 5 years after you start contributing to your Roth account, and after you are 59.5-years-old. Qualified withdrawals may also be made if you become disabled, or to your beneficiaries upon your death. This 5-year rule can often be confusing. If you open a Roth 401(k) and begin making contributions when you are 58-years-old, you then must wait until you are 63-years-old to begin distributions. You met the 59.5-year-old rule, but not the 5-year rule. Both must be met for the distribution to be qualified.
It is important to note that in 2020 there was a $2 trillion coronavirus emergency stimulus bill that allowed people under the age of 59.5 to withdraw up to $100,000 from traditional or Roth 401(k) without the 10% penalty. However, that was only valid for 2020. Penalties for those aged under 59.5 who withdraw money from their 401(k) accounts went back into effect on Jan 1, 2021.
You can withdraw from Roth 401(k) early, but you will have to pay taxes on any earnings you withdraw and you will potentially be subject to a 10% early withdrawal penalty. You can also avoid taxation on your earnings if your withdrawal is for a rollover. However, please consider these 3 reasons why you should not rollover.
Do I need to report Roth 401(k) on my taxes?
You do not report your Roth IRA and Roth 401(k) contributions on your tax return. However, keep track of your contributions over the years so you can see how your money grows over time.
Who can help me make decisions about a Roth 401(k)?
Roth 401(k) is a great retirement savings plan for you to consider. A financial planner can help you decide if it is the right choice for you. District Capital is one of the fastest-growing local fee-only financial planning firms in Washington, DC. Whether you want to open a Roth 401(k), max it out, or if you are changing jobs or a combination of all of these, we are here to help guide you. You will receive top-notch advice from our diverse team of financial experts, all with well-recognized designations and well-versed with your financial situation. Schedule a free discovery call with one of our fee-only financial planner.
Alvin Carlos, CFP®, CFA is an investment advisor and fee-only financial planner, in Washington, D.C that works with clients across the country. He has a Master’s degree in International Relations from SAIS-Johns Hopkins. Alvin is a partner of District Capital, a financial planning firm designed to help professionals in their 30s and 40s achieve their financial goals through smart investing, reducing taxes, retirement planning, and maximizing their money. Schedule a free discovery call to learn how we can help elevate your finances.