How exactly is a Roth 401(k) taxed? The essence is that you don't get a tax deduction when you contribute part of your pay to it, as you do with a traditional 401(k). Instead, a Roth 401(k) allows employees to contribute after-tax dollars. The payoff is that this money and its earnings over the years are not subject to income tax when you withdraw it after retiring.
These plans have only been available since 2006, but they are gaining in popularity as a way to establish a retirement income that is free from tax liability.
Not all company-sponsored retirement schemes offer a Roth 401(k), but the number of plans offering Roth in 401(k)’s has increased in the last few years.
Let's take a look at the tax nuances of Roth 401(k)s and how they differ from a traditional 401(k) and a Roth individual retirement account (IRA).
Key Takeaways
- The main advantage of a Roth 401(k) is that withdrawals are tax-free in retirement, as long as you've had the account for five years.
- Like other retirement accounts, distributions taken before age 59½ are subject to a 10% early withdrawal penalty.
- Since there's no income limit, Roth 401(k) tax advantages can be particularly appealing to high earners.
Before you choose a Roth 401(k), consider the following tax consequences.
The Paycheck Hit
With any qualified retirement account—including the Roth 401(k)—no additional tax is due from year to year while the funds stay in the account.
However, with a Roth 401(k), the taxes on the income you contribute to the account are due that year. The Roth 401(k) lacks one of the biggest benefits of the traditional 401(k), which is the deferral of income tax on that money until years down the road, when you will withdraw it during retirement.
Moreover, the money paid into the traditional account is deducted from your gross income. Effectively, that means lower immediate income taxes paid, offsetting part of the contribution.
Contributions to a Roth 401(k) must be made by the employer'stax filing deadline.
The Retirement Hit
During retirement, there are big differences in the way each type of account is taxed.
If it is a Roth account, all of the taxes owed have already been paid. No further income taxes are due on either the contributions or the profits they earned over the years. This is the main benefit of a Roth account.
If it is a traditional account, taxes are owed on both the contributions and the earnings.
Employer Contributions
An employer may offer a matching contribution for either a Roth or a traditional 401(k). Not all employers do, but some will match up to 5% or more of the employee's contribution.
In either case, the employer match is pre-tax money. The amount contributed will be subject to income tax when it is withdrawn after retiring.
You might consider this a minor issue since the rest of your Roth account is tax-free. It might even be an advantage, offsetting the amount you owe for taxes on all of your income.
No Income Restrictions
A major tax advantage of a Roth 401(k) is the opportunity for higher-earning individuals to contribute more dollars into a retirement account that will be tax-free at retirement. Higher-income individuals do not qualify to open a Roth IRA, but they can contribute to a Roth 401(k).
For tax year 2024, the annual income limit for contributions to aRoth IRAis a modified adjusted gross income (MAGI) of $161,000, with a phase-out starting at $146,000, for single filers. For those who are married and filing jointly, the MAGI must be less than $240,000, with a phase-out starting at $230,000.
For 2023, it was $153,000 for singles with a phase-out starting at $138,000. For those married and filing jointly, MAGI must be less than $228,000, with phase-outs starting at $218,000.
The Roth 401(k) has no such income restrictions. Contributions are, however, limited to $23,000 per year for the tax year 2024 (it was $22,500 for 2023), with another $7,500 for participants age 50 and older for 2023 and 2024. These are the same contribution limits for a regular 401(k).
Required Minimum Distributions
There's a difference between how annualrequired minimum distributions (RMDs) are handled for a Roth 401(k) compared to a Roth IRA.
Roth IRAs do not mandate RMDs during the lifetime of the account holder. Roth 401(k)s did for 2022 and 2023, but not for 2024 and after. The good news is that the money is not taxable, unlike the money you take from a traditional 401(k). Even better, because Roth 401(k) distributions are not taxable, they have no impact on the taxability of your Social Security benefits.
The removal of the RMD requirement is also beneficial because once you take a distribution from your Roth 401(k), that money cannot continue to grow tax-free. Now you can let it grow in your Roth 401(k) account until you are ready to withdraw funds.
What Are the Contribution Limits for a Roth 401(k)?
For 2024, you can contribute up to $23,000 to a Roth 401(k). For 2023, it was $22,500. If you are 50 or older, you can contribute an additional $7,500 in both 2023 and 2024.
Can I Contribute to Both a Roth 401(k) and a Roth IRA?
Yes, you can contribute to both a Roth 401(k) and a Roth IRA up to the allowed contribution limits for both.
Is There a Downside to a Roth 401(k)?
The primary downside would be that the account is funded with after-tax dollars, which means you don't get a tax break when you fund the account. However, earnings grow tax-free. And when you withdraw money, you do not pay any taxes, as long as it's been five years since you first contributed to the account. This might offset the initial financial burden of funding the account with after-tax dollars. Such an account would be particularly beneficial to those who expect to be in a higher tax bracket when they retire.
The Bottom Line
The benefit of a Roth 401(k) and any Roth account is that earnings are not taxed. And because you already funded the account with after-tax dollars, you won't be taxed when you withdraw funds, as long as you follow the five-year rule. A Roth account can be a great way to enhance your retirement strategy, particularly if you have other retirement accounts where you will need to pay taxes when you withdraw funds, such as a traditional 401(k).
