The Roth 401(k) is 10 years old! With 62% of employers now offering this option, it's more likely than not that you can make Roth contributions to your 401(k) plan.1 Dependent on your situation, the long-term tax savings could be significant if implemented correctly.
What is a Roth 401(k) plan?
A Roth 401(k) plan is simply a traditional 401(k) plan that permits contributions to a designated Roth account within the plan. Roth 401(k) contributions are made on an after-tax basis, just like Roth IRA contributions. This means there's no up-front tax benefit, but if certain conditions are met both your contributions and any accumulated investment earnings on those contributions are free of federal income tax when distributed from the plan.
Who can contribute?
Anyone! If you're eligible to participate in a 401(k) plan with a Roth option, you can make Roth 401(k) contributions. Although you cannot contribute to a Roth IRA if you earn more than a specific dollar amount, there are no such income limits for a Roth 401(k).
Are distributions really tax free?
Because your contributions are made on an after-tax basis, they're always free of federal income tax when distributed from the plan. But any investment earnings on your Roth contributions are tax free only if you meet the requirements for a "qualified distribution."
In general, a distribution is qualified if:
- It is made after the end of a five-year holding period, and
- The payment is made after you turn 59½, become disabled, or die
The five-year holding period starts with the year you make your first Roth contribution to your employer's 401(k) plan. For example, if you make your first Roth contribution to the plan in December 2016, then the first year of your five-year holding period is 2016, and your waiting period ends on December 31, 2020. Special rules apply if you transfer your Roth dollars over to a new employer's 401(k) plan.
If your distribution isn't qualified (for example, you make a hardship withdrawal from your Roth account before age 59½), the portion of your distribution that represents investment earnings will be taxable and subject to a 10% early distribution penalty, unless an exception applies. (State tax rules may be different.) If at all possible, the early distributions from Roth IRAs should generally be avoided in light of the significant long-term advantages of keeping the money in their.
How much can I contribute?
There's an overall cap on your combined pretax and Roth 401(k) contributions. In 2016, you can contribute up to $18,000 ($24,000 if you are age 50 or older) to a 401(k) plan. You can split your contribution between Roth and pretax contributions any way you wish. For example, you can make $10,000 of Roth contributions and $8,000 of pretax contributions. It can be flexible based on your situation.
Can I still contribute to a Roth IRA?
Yes. Your participation in a Roth 401(k) plan has no impact on your ability to contribute to a Roth IRA. You can contribute to both if you wish. Be cognizant, however, of more restrictive income limits with Roth IRAs.
What about employer contributions?
While employers don't have to contribute to 401(k) plans, many will match all or part of your contributions. Your employer can match your Roth contributions, your pretax contributions, or both. But your employer's contributions are always made on a pretax basis, even if they match your Roth contributions. In other words, your employer's contributions, and any investment earnings on those contributions, will be taxed when you receive a distribution of those dollars from the plan.
Can I convert my existing traditional 401(k) balance to my Roth account?
Yes! If your plan permits, you can convert any portion of your 401(k) plan account (your pretax contributions, vested employer contributions, and investment earnings) to your Roth account. The amount you convert is subject to federal income tax in the year of the conversion (except for any after-tax contributions you've made), but qualified distributions from your Roth account will be entirely income tax free. The 10% early-distribution penalty generally doesn't apply to amounts you convert.2
What else do I need to know?
Like pretax 401(k) contributions, your Roth contributions can be distributed only after you terminate employment, reach age 59½, incur a hardship, become disabled, or die. Also, unlike Roth IRAs, you must generally begin taking distributions from a Roth 401(k) plan after you reach age 70½ (or, in some cases, after you retire). But this isn't as significant as it might seem, because you can generally roll over your Roth 401(k) money to a Roth IRA if you don't need or want the lifetime distributions.
Integration is Key
As with all planning strategies, the Roth 401k should be reviewed in context of the other critical parts of your financial plan, including income taxes and retirement planning. Decisions like these should not be made in a compartmentalized fashion and analysis could really pay off.
1 Plan Sponsor Council of America, 58th Annual Survey of Profit Sharing and 401(k) Plans (2015) (Reflecting 2014 Plan Experience)
2The 10% penalty tax may be reclaimed by the IRS if you take a nonqualified distribution from your Roth account within five years of the conversion.
Modified by Oasis Wealth Planning Advisors with initial preparation by Broadridge Investor Communication Solutions, Inc. Copyright 2016.