The Roth 401(k) option
The complexities of saving for retirement continue to transform. Of course, there are many investment strategies to consider when developing your retirement savings plan. The two primary avenues for tax-favored retirement savings are government-sponsored programs and employer-sponsored programs.
Understanding these options can help you make informed decisions regarding your long-term financial goals. The world of employer-sponsored programs can offer great options and strategies from both the employer and employee perspective. One of these options is a Roth 401(k) account.
A Roth 401(k) is an employer-sponsored retirement investment account. Similar to a Roth IRA account, a Roth 401(k) is funded with after-tax dollars. However, unlike a Roth IRA, a Roth 401(k) does not phase out higher income earners. A Roth 401(k) account may be an attractive option if you are a high-income earner, have been phased out from being allowed to contribute to a Roth IRA account, and are looking to save after-tax dollars for retirement.
This designated Roth contribution may be available through your organization’s 401(k), 403(b) or governmental 457(b) retirement plan. Although this article focuses on the Roth 401(k), these concepts are applicable to all of the above-mentioned accounts. A Roth 401(k) is housed within a company’s 401(k) plan; you cannot contribute to a Roth 401(k) unless your employer-sponsored retirement plan allows for this type of contribution. A traditional 401(k) is funded with pre-tax employee elective contributions, whereas a Roth 401(k) is funded with after-tax employee elective contributions. As a result, contributions to your Roth 401(k) are included in your gross income, meaning you pay taxes on these contributions in the year the contribution was made.
Annual contribution limits increased this year to $19,000. If you are over the age of 50, you also can utilize a $6,000 catch-up contribution. Flexibility is permitted with 401(k) contributions, as contributions may be made as follows:
- 100 percent of your contribution to the traditional 401(k) account
- 100 percent of your contribution to the Roth 401(k) account
- A portion to your traditional account and a portion to your Roth account
However, the total amount of your contributions among these accounts may not exceed the annual contribution amount of $19,000 (plus the $6,000 catch up contribution) for 2019.
It’s important to keep in mind that withdrawals from a Roth 401(k) are treated somewhat differently than a traditional 401(k) withdrawal. Withdrawals of both contributions and earnings from your traditional 401(k) are subject to federal and most state income taxes. On the other hand, withdrawals of contributions and earnings from your Roth 401(k) are tax free, so long as the withdrawal is a qualified distribution. To be a qualified distribution, the account owner must hold the account for at least 5 years and the withdrawal request must be made due to a disability, death or on or after attainment of age 59 ½.
There are no income restrictions or phase-out thresholds applied to Roth 401(k) contributions. However, like a traditional 401(k) account, distributions from a Roth 401(k) account must begin no later than 70.5 years of age, unless the account owner is still working and not a 5 percent or more owner. Another interesting caveat is that employer contributions are only made into the traditional 401(k) account. This means all company matching, profit-sharing, and/or safe harbor contributions always will be deposited into the participant’s traditional 401(k) account regardless of how the participant is allocating their contributions among their traditional 401(k) account and their Roth 401(k) account. Therefore, all employer contributions remain pre-tax contributions.
Roth 401(k)s are unique retirement savings vehicles that blend some features of a traditional 401(k) and a Roth IRA account. It’s best to speak with your Certified Financial Planner about whether Roth 401(k) contributions would help achieve your financial goals, or if adding a designated Roth option would be a valuable addition to your organization’s retirement plan.