How Do Roth 401(K) Plans Work?

If your company offers a 401(K) plan to your employees, some of them may inquire about treating the contributions as Roth contributions. This is how you can be prepared to answer their questions about Roth 401(k) contributions.

What is a Roth 401(k)?

This type of employer-provided retirement account allows the employee to designate Roth contributions of up to $18,000 or $24,000 if 50 or older (reference IRC Section 402(g)) for the 2015 tax year. Similar to a Roth IRA, the contributions are made with after-tax dollars, but appreciate tax-free over time. A key benefit of the Roth 401(K) is that there is no income limit as is the case with a Roth IRA. You can earn $1 million and still be eligible.

How does this compare to a traditional 401(k)?

The contribution limits are both the same, but Roth contributions are taxed now while contributions for a traditional 401(K) are deferred until you withdraw the funds. Thus, it’s generally best for young employees to contribute to a Roth 401(K) when their tax rate is lower than it will be when they eventually withdraw from the account. A traditional 401(K) on the other hand can be more advantageous for individuals that are in a higher tax bracket now than they will be later in life.

Roth 401(K) contribution can be beneficial for older workers too

There are a number of reasons why even baby boomers may want to consider a Roth 401(K). First, this type of plan provides greater flexibility as you can avoid required minimum withdrawals after age 70 1/2. You would just need to roll over your Roth 401(k) to a Roth IRA. In addition, if you need the monies for an emergency, you will not have to worry about potential large tax liabilities as is the case with a traditional 401(K) plan. Furthermore, it’s important to acknowledge that having tax-free monies when you retire can be very useful as it will not impact the taxability of your Social Security benefits or your Medicare eligibility.

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