As with a 401(k), employers can choose to match any contributions you make through the plan. Unlike your contributions, matching employer contributions are made pre-tax into a separate account. As a result, when you take Roth 401(k) distributions in retirement, they will be partially taxed.
Distributions from your own contributions will be tax-exempt.Distributions from employer contributions will be taxed.
There can be definite tax advantages to a Roth 401(k), but the biggest pro is that once you are retired, you can withdraw your funds tax-free. If your employer chooses to offer a Roth 401(k) option, you’ll be able to select how much you want to contribute each pay period from your after-tax income. These contributions will go into an account and grow tax-free. Any matching contributions your employer makes will go into a separate, standard 401(k) account and grow tax-deferred until you take distributions.
Contribution Limits for Roth 401(k)s
The annual contribution limits for Roth 401(k)s are the same as for traditional 401(k)s:
For 2022, you can contribute up to $20,500 of pretax income to a 401(k). If you are 50 or older, you can contribute another $6,500 in what are called “catch-up contributions.“For 2023, you can contribute up to $22,500 of pretax income to a 401(k). If you are 50 or older, you can contribute another $7,500 in catch-up contributions.
Roth 401(k)s have much higher contribution limits than Roth individual retirement accounts (IRAs), which have an annual contribution limit of $6,000 in 2022 ($6,500 in 2023) and $7,000 if you’re age 50 and older ($7,500 in 2023).
Requirements for Withdrawals
Withdrawals from the employee-contributed account are tax-free as long as you have been contributing to the plan for at least five years and one of the following is true:
You are at least 59 1/2 years old.You become disabled.Beneficiaries take distributions upon your death.
Required Minimum Distributions (RMDs)
As with a traditional 401(k), you must begin taking minimum distributions from your Roth 401(k) by age 72 (age 70 1/2 if you reached age 70 1/2 before Jan. 1, 2020) unless you are still working and don’t own 5% or more of the business.
Example of a Roth 401(k)
Let’s say you decide to participate in a Roth 401(k) offered by your employer. You earn $60,000 and opt to have 6% of your salary contributed to the Roth 401(k) each year. Your employer offers a matching program of 50% of the first 6% that you contribute. In other words, your employer will add 3% of your salary to your retirement account each year as long as you contribute 6%. The amount saved will grow over the years, depending on your investment choices, but you won’t pay any capital gains taxes on those earnings. In retirement, you can take your contributions and the earnings on those contributions out of your Roth 401(k) tax-free since you received no upfront tax break in the years of the contributions. However, the withdrawals from the employer matching will be taxed at your current income tax rate in retirement.
Roth 401(k) vs. Traditional 401(k)
A Roth 401(k) is similar to a traditional 401(k) in many respects, with one main difference—it deducts your contributions (but not employer contributions) after tax, meaning taxes have already been taken out of your income, before making contributions. As a result, you may not have to pay taxes on your distributions and income when you retire. With a traditional 401(k), you make pre-tax contributions, meaning your taxable income is reduced by the contribution amounts, lowering your tax bill in the year of the contribution. However, your distributions are taxed in retirement. When considering either a traditional 401(k) or a Roth 401(k), it’s helpful to estimate the tax bracket in which you will be during retirement, as this will affect the amount of tax you may have to pay. If you expect to be in a higher tax bracket when you retire, a Roth 401(k) may make more sense since your withdrawals will be tax-free. However, if you estimate that you will be in a lower tax bracket when you retire, then contributing to a traditional 401(k) makes more sense.
How Much Should I Contribute to Retirement?
Some experts suggest putting aside 10% to 15% of your pre-tax income for retirement, but you may need to work up to this amount. If you have an employer matching program, be sure to contribute enough to qualify for the match since it’s free money added to your retirement savings. For example, if your employer offers a 5% match, they’ll contribute 5% of your salary as long as you also contribute 5%. In other words, the matching helps you double your savings rate. However, you must participate in the Roth 401(k) or traditional 401(k) to qualify for the match. So, be sure to contact the retirement plan administrator to see if there’s a matching program and how you can take advantage of it.
What Happens If I Change Jobs?
If you change jobs, you can roll your 401(k) into another 401(k) or an IRA. When you do this, you should roll it into the same type of account. For example, if you have a Roth 401(k), you can roll it into a Roth 401(k) or a Roth IRA; you can’t convert distributions from a Roth 401(k) to a traditional 401(k) or IRA. You can roll a traditional 401(k) into a Roth 401(k) or IRA, but you will be expected to pay taxes at the time of the rollover. If you do not have the money available, it is best to roll it into a traditional account instead. These rollover rules can get complicated, so consider talking to your CPA or financial planner and to decide how a Roth 401(k) could benefit you and the right way to do any rollover. Your financial planner can also help you to develop an overall investment strategy that will help you build wealth over time. Conversely, contributions to a Roth 401(k) are made with after-tax dollars, meaning income taxes have already been deducted from your paycheck, giving you no upfront tax benefit in the year of the contribution. However, you have the potential of no income taxes on withdrawals from a Roth 401(k) in retirement.
