Roth 401(k) has become more popular. Among the various options available, three popular choices are Roth 401(k), Traditional 401(k), and Roth IRA. Each of these accounts has its own set of rules, benefits, and considerations. Let’s first compare and contrast these three retirement account options to better understand what they can do to serve for your retirement investment need.
Roth 401(k)
A. Contributions and Tax Treatment
- 1. After-Tax Contributions: Roth 401(k) contributions are made with after-tax dollars.
- 2. Tax-Free Withdrawals: Qualified withdrawals from a Roth 401(k) are tax-free in retirement.
B. Employer Matching Contributions
- 1. Matching Contributions: Employers can make matching contributions to a Roth 401(k), which are subject to tax.
- 2. Employer Match Tax Treatment: Employer matching contributions are tax-deferred and grow tax-free until withdrawal. The matching contributions are not counted as the employee’s tax liability. The employer’s matching contribution is separate from the employee’s after-tax contributions and does not affect the employee’s tax liability. The matching contributions are subject to tax when withdrawn in retirement, along with any investment earnings.
C. Required Minimum Distributions (RMDs)
- 1. RMDs Not Required: Roth 401(k) accounts are not subject to RMDs during the account holder’s lifetime.
- 2. RMDs for Inherited Accounts: Inherited Roth 401(k) accounts may be subject to RMDs.
D. Income Limits
No Income Limits: Roth 401(k) contributions do not have income limits.
Traditional 401(k)
A. Contributions and Tax Treatment
- 1. Pre-Tax Contributions: Traditional 401(k) contributions are made with pre-tax dollars, reducing taxable income.
- 2. Tax-Deferred Growth: Investment earnings within a Traditional 401(k) grow tax-deferred until withdrawal.
B. Employer Matching Contributions
- 1. Matching Contributions: Employers can make matching contributions to a Traditional 401(k), which are tax-deferred.
- 2. Tax Treatment at Withdrawal: Withdrawals from a Traditional 401(k) are subject to ordinary income tax rates.
C. Required Minimum Distributions (RMDs)
- 1. RMDs at Age 72: Traditional 401(k) account holders must begin taking RMDs by April 1st of the year following the year they turn 72.
- 2. RMDs for Inherited Accounts: Inherited Traditional 401(k) accounts may be subject to RMDs.
D. Income Limits
No Income Limits: Traditional 401(k) contributions do not have income limits.
Roth IRA
A. Contributions and Tax Treatment
- 1. After-Tax Contributions: Roth IRA contributions are made with after-tax dollars.
- 2. Tax-Free Withdrawals: Qualified withdrawals from a Roth IRA are tax-free in retirement.
B. Employer Contributions:
- 1. No Employer Contributions: Roth IRA accounts are individual retirement accounts, and employers cannot contribute to them directly.
- 2. Individual Contributions: Individuals can contribute to a Roth IRA based on income eligibility. More on this later.
C. Required Minimum Distributions (RMDs)
- 1. RMDs Not Required: Roth IRA accounts are not subject to RMDs during the account holder’s lifetime.
- 2. RMDs for Inherited Accounts: Inherited Roth IRA accounts may be subject to RMDs.
D. Income Limits
Roth IRA contributions are subject to income limits that determine eligibility. These limits are based on the modified adjusted gross income (MAGI) of the account holder. For the tax year 2021, the income limits for Roth IRA contributions are as follows:
- For single filers: The ability to make a full Roth IRA contribution is phased out for individuals with a MAGI between $125,000 and $140,000. Contributions are not allowed for individuals with a MAGI of $140,000 or higher.
- For married couples filing jointly: The ability to make a full Roth IRA contribution is phased out for couples with a joint MAGI between $198,000 and $208,000. Contributions are not allowed for couples with a joint MAGI of $208,000 or higher.
Please note that these income limits are subject to change each year.
From the above, we can see that the biggest advantage of Roth 401(k) over Roth IRA is that it doesn’t have any income limit. This makes it ideal for high income earners to save more through Roth 401(k). Unfortunately, not all the employers in the United States offer Roth 401(k). In fact, until recently, only very few offer it to their employees.
Brief History of Roth 401(k)
Roth 401(k) was introduced as part of the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) and became available to employees starting in 2006. Unlike traditional 401(k) plans, which allow pre-tax contributions, the Roth 401(k) offers after-tax contributions.
Initially, the Roth 401(k) option was not widely adopted by employers. Many companies were hesitant to offer it due to uncertainties surrounding its tax treatment and administrative complexities. However, over time, more employers recognized the benefits of providing this retirement savings option to their employees. This was also partly because of more requests from employees.
Although not all companies offer the Roth 401(k), its popularity has grown steadily. Employers that do offer this option aim to provide their employees with additional flexibility in retirement planning and tax advantages. It has become especially popular in technology companies, especially newly formed startups.
Combined Contribution Limits
Another important factor to watch out is that IRS stipulates that the combined amount contributed to all Roth 401(k), 403(b) accounts and traditional, pre-tax accounts (401(k), 403(b) ) in any one year for any individual is limited (under IRC Section 402(g)). The limit is $22,500 in 2023 ($20,500 in 2022; $19,500 in 2020 and 2021; $19,000 in 2019), plus an additional $7,500 in 2023 ($6,500 in 2020, 2021 and 2022 and $6,000 in 2015 – 2019) if you are age 50 or older at the end of the year, so called catch up contribution.
This combined (Roth 401k and Traditional 401k) contribution limit makes Roth 401(k) less appealing for those who want to get tax-deferral as much as possible in a given year. However, Roth 401(k) can be a very useful if one expects to have a higher tax rate in retirement or one experiences a lower income tax in a particular year. An example is that if a person has some business loss in a year that can be used to offset the personal income, then Roth 401(k) contribution can be considered instead of a traditional 401(k). Similarly, for those who are considering back door Roth IRA conversion, Roth 401(k), if available, can be considered. There are many tax strategies and scenarios to consider and you are recommended to consult tax professionals.