What is a Roth 401(k)?

A Roth 401(k) is one of a number of employer-sponsored retirement savings plans in the marketplace today. As such, for a person to participate, they must be an employee of a company that offers a Roth 401(k) plan to their employees.

Most people have grown accustomed to workplace retirement plans whereby a portion of one’s paycheck is deposited into a retirement savings account of some kind to be withdrawn in one’s retirement year. Examples of other plans would be the Traditional 401(k), 403(b) or the governmental 457(b). We’ll focus here on the Roth 401(k) and how it compares to the Traditional 401(k) plan.

The Traditional 401(k) was first introduced in 1978. Since 2006, employers have been given the option to amend their Traditional 401(k) plan to allow employees to choose between either Traditional or Roth 401(k) tax treatment of either all or a portion of their contributions.

The Basics of the Traditional 401(k)

With the original, or “traditional”, 401(k), employee contributions are taken from each paycheck on a pre-tax basis, meaning that taxes aren’t paid on contributed amounts in the year that the income was earned. Further, contributions earn investment income within the account tax-free while in the account.

When withdrawals are made in the retirement years as defined by the plan and regulated by tax law, ordinary income taxes are paid on both the previously untaxed contributions as well as the investment earnings on those contributions. Hence, we call the Traditional 401(k) account a tax-deferred account, because taxes are eventually paid on everything.

The Roth 401(k) Difference

Unlike the Traditional 401(k), income taxes are withheld by the employer on the amounts contributed to the Roth 401(k), such that contributions are made after-taxes. Hence there is no tax benefit to the employee in the tax year the contribution is made. As with the Traditional 401(k), investment income earned within the account is tax-free while it remains in the retirement account.

The tax benefits of the Roth 401(k) are realized during the retirement years. Whereas withdrawals of contributions and earnings from a Traditional 401(k) are taxed as ordinary income, properly taken withdrawals from a Roth 401(k) are never taxed. Remember that the contributions were already taxed in the year of the contribution. So, the principle tax benefit is that all investment income earned in the account is never taxed, neither while in the account or when withdrawn properly as defined by tax law.

What About Employer Matching Contributions?

The tax difference between the Traditional and Roth 401(k) plans only applies to the contributions made by the employee. Employer matching contributions to a Roth 401(k) are made pre-tax as they are with the Traditional 401(k), and withdrawals of both the amount contributed by the employer and any investment income earned on those contributions while in the account are taxed as ordinary income when withdrawn during retirement years. As such, employer matching contributions are held in a separate account for ease of administration.

Roth 401(k) Eligibility Requirements

Eligibility requirements are defined by the employer within certain guidelines. Some will allow participation starting with the first paycheck received and some require a waiting period. Waiting periods can range from one month to a full year. Further, there may be a different waiting period established as to when employer matching contributions begin. Consult the plan’s benefit enrollment materials to learn your specific requirements.

Roth 401(k) Contribution Limits

A maximum annual contribution is set each year by the tax authorities. In 2014, the maximum contribution is set, for example, at $17,500. Employees over the age of 50 are allowed a “catch-up contribution” of an additional $5,500. The annual contribution can never exceed your annual compensation for the same year.

Employer Matching Contributions

Employers are not required to make matching contributions. Some employers might match contributions right away and some might have a waiting period. Some may increase the amount of the matching contribution based on years of service with the company. Consult the plan’s benefit enrollment materials to learn the specific features of your plan.

Vesting Issues with a Roth 401(k)

As with a Traditional 401(k), vesting schedules for employer matching contributions are defined by the employer within certain guidelines. Some employers allow for immediate vesting where some, usually as part of a plan to retain employees, require that some time passes before matching contributions are vested. In these cases, when an employee changes jobs, they are likely to lose some of the matching contributions that have yet to vest.

What Investment Options are Available in a Roth 401(k)?

Available investment options can vary widely. Most plans are set up with an administrator that offers a limited number of funds to choose from. The number of options vary, with the average falling from five to fifteen funds to choose from. Some Roth 401(k) plans permit self-directed investments, offering a much greater variety of investment options. And some plans allow for investment in the employer’s company stock.

Should You Contribute to a Traditional or Roth 401(k) – or both?

The answer to this usually comes down to tax considerations that are very specific to each individual person. In general, those who are in lower tax brackets in the year of the contribution are considered better off contribution to a Roth 401(k), while those in a higher tax bracket, such as during their peak earning years, are better off contributing to the tax-deferred Traditional 401(k).

However, many other considerations exist, such as if and when withdrawals will be needed in retirement years as well as how funds will be transferred to heirs up death of the account holder. As such, it is important to consult with a tax professional or independent financial advisor when making such decisions.

Converting Money between Traditional and Roth 401(k)’s

It is not permissible to convert money held in a Roth 401(k) into a Traditional 401(k). However, under certain circumstances, it may be advisable to convert money from a Traditional 401(k) into a Roth 401(k). When doing so, there is a strong chance that some taxes will be paid as part of the conversion. It is very important to consult with a tax professional or independent financial advisor when making such a decision.

Make an Informed Decision

There is a great deal at stake when making decisions related to building wealth through retirement savings accounts. Small errors can be magnified over time and the benefits of smart decisions made early can also be magnified over time. Parameters of plans can vary widely from employer to employer and tax law can be complex. Further, each individual has different needs and considerations that are specific to their own life goals and situation. As with any tax-related decision, it is important to discuss matters first with a tax professional or independent financial advisor to learn what’s best for you and your family.

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What is the difference between Traditional and Roth 401(k)s and IRAs?
401(k) rollover options when making a job change

About the Author

Todd E. Frank, CPA/PFS, MBA is the President and CEO of Frank Financial Advisors, a Registered Investment Advisory Firm (RIA) serving clients nationwide from our headquarters in Carlsbad, San Diego, California. As an RIA, Frank Financial Advisors is able to offer truly independent, fee-only financial advisory services.