Roth 401(k) contributions are an elective contribution made by an employee/participant to a 401(k) plan on an after-tax basis. Assuming a Roth distribution meets all applicable requirements, distributions from a Roth account (including investment gains) are income tax-free.
Roth 401(k) contributions are subject to all the rules that a pre-tax elective deferral is subject to, plus a few more. In order to have a tax-free distribution (or “qualified distribution”), several requirements must be met. This means that most of the additional tax law rules apply to Roth contributions relate to the tax status of the distribution. Plans may also impose additional requirements or restrictions on Roth accounts or contributions – these restrictions also typically relate to the qualified status of the Roth account.
Pre-tax vs Post-tax Contributions
Pre-tax contributions are deducted from pay before taxes. Pre-tax contributions grow in a 401(k) plan without tax. Once pre-tax contributions (and their investment gains) are distributed from the plan, income tax will apply to the distribution (both the original contribution and its gains).
Roth/post-tax contributions are contributed to the plan from earnings that have already had income tax deducted. The contributions grow in the plan without tax and qualified distributions from a Roth account (including investment gains) are income tax-free.
Determining which contribution type is best for a particular investor depends on numerous factors. The primary factor is whether the tax rate now will be higher or lower than when the withdrawal takes place. This will depend upon the tax bracket and tax law policy - both of which generally cannot be known for certain. Other factors to consider are the length of time before retirement and expected investment gains. Numerous resources are available on the internet to test out different assumptions (age, income, investment amounts, etc.) and compare which type of contribution might be the most lucrative.
Roth 401(k) Contributions are Not Subject to Roth IRA Rules
The Income restrictions that apply to Roth IRAs do not apply to Roth contributions to 401(k) plans. The contribution limits that apply to a Roth IRA also are not related to the contribution limits for Roth contributions in a 401(k) plan.
Only Employees Make Roth 401(k) Contributions and/or In-Plan Roth Rollovers
Employers can’t make Roth contributions. For example, if an employer matches an employee’s Roth contribution, the employer match must be a pre-tax contribution and cannot be allocated to a Roth account.
Employees can make Roth contributions as elective deferrals (reductions from pay). Employees can also convert pre-tax employer contributions to a Roth account, assuming the rules of the plan allow it. This conversion from pre-tax to post-tax/Roth account is typically called an “In-plan Roth Rollover”. Plans must place numerous restrictions on which accounts can be rolled over to a Roth account and when. Employees will have to pay income tax on the assets rolled into the Roth account in the year of the rollover. Note that Roth contributions can never be converted back to a pre-tax account.
A qualified distribution from a designated Roth account is not included in gross income. There are 2 requirements for a distribution from Roth account to be a qualified distribution:
Both requirements must be met for a distribution from a Roth account to be qualified. If a participant is age 60 but only began making Roth contributions 2 years ago, the distribution is not qualified. The earnings portion of a nonqualified Roth distribution will be taxed as income.
Note that termination of employment is not a qualifying event for a qualified distribution. If a participant loses his or her job within 5 years of his or her first Roth contribution and chooses to withdraw the Roth contributions at termination, the distribution of the Roth account will be a nonqualified distribution. The participant can avoid the additional tax by waiting to withdraw or by rolling the account to a Roth IRA or another employer plan that permits rollovers of Roth accounts.
Roth 401(k) Contributions are Subject to 401(k) Rules
Except for income tax treatment, Roth 401(k) contributions are treated just like pre-tax contributions and subject to the same limits and requirements. Roth and pre-tax contributions are combined to ensure a participant does not exceed the annual contribution limits ($18,000 in 2016) permitted by law. Note that plans can implement a lower contribution limit, typically as a percentage of compensation or a dollar limit.
Roth contributions can also be contributed as age 50 catch-up contributions in the same manner as pre-tax elective deferrals (assuming the plan permits catch-up contributions). Again, pre-tax catch-up contributions are combined with Roth catch-up contributions to ensure the overall limit on catch-ups is not exceeded ($6,000 in 2016).
Plans May Have Additional Restrictions on Roth Accounts
Plans may also have additional rules that apply to Roth accounts. For example, the plan may specify that if assets are distributed, pre-tax accounts are distributed first. Requiring pre-tax contributions to be distributed first can help the plan reduce the amount of nonqualified distributions.
Plans could restrict in-service distributions to pre-tax accounts in order to avoid needing to determine whether the distributions are qualified. Plans may allow in-service distributions of Roth accounts but limit distributions to Roth accounts that are eligible for a qualified distribution. For example, if a plan permits hardship distributions from elective deferrals and qualified Roth accounts, a participant who is less than age 59.5 (and not disabled) will not be able to access Roth contributions if they experience a hardship. They will be limited to pre-tax 401(k) accounts.
Roth contributions to 401(k) plans are incredibly popular. Because the determination of whether a distribution is qualified depends upon when the participant first made Roth contributions, there is an additional administrative burden placed on plans that offer Roth contributions that do not apply to other account types. However, giving participants the power to select when income tax applies to their contributions can be a great benefit.