Should You Take Advantage of a Roth 401(k) Plan?

While most Americans are fairly well-versed in Roth IRAs – a retirement vehicle in play since 1997 – fewer are as familiar with the Roth 401(k). In essence, the Roth 401(k), an employer-sponsored investment savings plan, combines advantageous features of the Roth IRA and a traditional 401(k) plan. More than 60 percent of employers now offer this retirement savings plan option.

In light of the tenth anniversary of the Roth 401(k), Smith and Howard answers eight questions about this attractive savings option.

1) What are the key differences between a traditional and Roth 401(k)?

Both plans offer attractive retirement savings benefits. The biggest difference between the two is the timing of when you will be taxed. Similar to a Roth IRA, you will be taxed up front with a Roth 401(k). Contributions come out of your paycheck after it has been taxed.

Your contributions accumulate tax-free, and you don’t pay taxes on investment earnings on your Roth contributions if you meet the requirement for qualified distributions when you access the money in retirement. With traditional 401(k)s, contributions are made with pre-tax dollars, but your withdrawals in retirement are taxed as ordinary income.

2) What is considered a “qualified distribution?”

Roth contributions are always free of federal income tax when they are distributed from the plan. Investment earnings, however, must meet certain requirements for a “qualified distribution.” 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 59 ½, become disabled or die

The five-year period begins the year you make your first Roth contribution to your employer’s 401(k) plan. Special rules are in effect if you transfer your Roth funds to a new employer’s plan. A portion of your investment earnings will become taxable and subject to a 10 percent penalty if your distribution doesn’t meet the qualified distribution guidelines.

3) What are the contribution limits for a Roth 401(k)?

The annual contribution limit for the Roth and traditional 401(k) is a combined $18,000 in 2016. If you are age 50 or older, you can contribute an additional $6,000.

4) What about employer contributions?

While there are not matching requirements, many employers will match a portion of your contributions. This applies to Roth contributions as well as pre-tax contributions. Keep in mind that your employer’s contributions are always made on a pre-tax basis, even when you have elected to make Roth contributions. That means that the employer contributions, as well as any investment earnings on those contributions, will be taxed upon distribution.

5) Who can contribute to a Roth 401(k)?

As long as you are eligible to participate in a 401(k) plan that has a Roth option, you can make contributions. Unlike the Roth IRA that has an income cap, there are no such limits for a Roth 401(k).

6) What are the withdrawal requirements?

You generally do not have to take required minimum distributions (RMD) from either a traditional 401(k) or a Roth 401(k) if you are still working for the employer that sponsors the plan. If, however, you are retired, you do need to take RMDs from either kind of account after you turn age 70½, although your Roth 401(k) withdrawals will be tax-free. The IRS provides an IRA Required Minimum Distribution Worksheet to help individuals determine their required withdrawal.

7) Can the funds in a Roth 401(k) be tapped before age 59 ½?

Special tax consequences apply to hardship withdrawals from Roth 401(k) contributions.

Typically, if withdrawals are distributed before age 591⁄2, the taxable portion of the payment is subject to an early distribution 10% tax penalty. However, this extra tax does not apply to the payment if the participant is:

• At least age 55 when separated from service
• Terminated due to disability
• Paid in equal (or almost equal) payments over the life expectancy of the participant or joint life expectancy of the participant and beneficiary
• Using the payment to cover certain medical expenses that can be deducted on a tax return
• Deceased

8) Can an individual participate in both a traditional and Roth 401(k) plan?

The good news is that many plan sponsors offer both plans, and many individuals decide to participate in both. This could be a wise choice if you are uncertain of what your tax bracket will be in retirement. By participating in both plans, you would be diversifying your portfolio. However, keep in mind that the total amount of contributions cannot exceed $18,000 (or $24,000 if you are age 50 or older).

As always, it is important for you to consult with your tax and/or financial advisor on which plan may be best for you. If you have any questions, please contact Smith and Howard’s tax department at 404-874-6244 or simply fill out the form below.