Employers that already offer a 401(k) plan to their employees can add the opportunity for them to make Roth 401(k) contributions to maximize their retirement savings.
Fast facts about an employer-sponsored Roth 401(k)
- A Roth 401(k) is a traditional 401(k) plan that accepts Roth 401(k) contributions. 403(b) plans can also allow Roth contributions.
- As with Roth IRA accounts, the 401(k) contributions are made on an after-tax basis.
- Therefore, the Roth 401(k) contributions and all accumulated earnings on those contributions are distributed tax free (no federal income tax). Investment earnings on the Roth contributions are tax free if the requirements for a qualified distribution are met.
- A Roth 401(k) may work well for people who expect to be in a high tax bracket when they retire; those who contribute to a Roth 401(k) do not pay federal taxes on their investment returns (more on this below).
Why add a Roth 401(k)?
1 – Roth IRAs have income restrictions regarding who can contribute (if the IRA owners earn more than a certain dollar amount). However, the Roth 401(k) allows employees to make Roth contributions regardless of salary level, as soon they are eligible to participate in the company’s 401(k) plan.
2 – Employees may also contribute to a Traditional or Roth IRA outside of the 401(k) plan participation, enabling even greater retirement savings (up to $6,000 in 2022 or $7,000 for employees who are age 50+).
NOTE: The ability to contribute to a Roth IRA may be limited by the taxpayer’s modified adjusted gross income (MAGI); and deductible contributions to a Traditional IRA may also be limited by one’s MAGI or participation in a 401(k) plan.
Roth 401(k) contributions
The combined pre-tax and Roth 401(k) contributions are capped at $20,500 in 2022, with an additional $6500 catchup contribution for those age 50 or older (for a total of $27,000) to a 401(k) plan. Participants may split their contribution between Roth and pre-tax contributions any way they prefer.
Note that if the individual is contributing to another employer’s 401(k), 403(b), SIMPLE, or SARSEP plan, the total combined contributions to all plans may not exceed the annual limit.
In many cases, employers are not required to contribute to the 401(k) plan but may choose to offer a match to the pre-tax and/or Roth contributions.
Employer contributions are always made on a pre-tax basis, so those contributions and investment earnings on them are not taxed until funds are distributed to the employee from the plan. Note that the employer contributions (whether dollar-for-dollar or a percentage of salary) do not count toward the employee’s annual deferral limit.
Roth 401(k) distributions
As with all Roth accounts, there are qualified and unqualified distributions.
- A qualified distribution is one that is made after the end of a five-year waiting period and the payment is made after the participant turns 59½, becomes disabled, or dies.
- If the distribution is not qualified, the portion of the distribution that represents investment earnings on the Roth contributions will be taxable and subject to a 10% early distribution penalty unless certain exceptions apply.
- Unlike a Roth IRA, participants must begin taking required minimum distributions (RMDs) from a Roth 401(k) plan after reaching age 72 (or in some cases, after they retire). However, the Roth 401(k) dollars can usually be rolled over into a Roth IRA if the taxpayer does not need or want the lifetime distributions.
- NOTE: The rollover must occur prior to the year a participant turns 72; otherwise, an RMD must be taken.
- Rollovers of all or part of a distribution into a Roth IRA or another employer’s Roth 401(k) or 403(b) may avoid a federal tax event.
- Since the Roth IRA funds are not subject to RMD requirements until the death of the IRA owner, the assets may be a strong estate planning tool.
For more information about how to set up or add a Roth feature to your current plan, or for further insights into how Roth 401(k) plans work, contact your Intac FuturePlan consultant today.