Many employers offer their employees a Roth 401(k), which combines the tax-free withdrawal aspect of a Roth and the higher contribution level of a 401(k).
More than 14 million American households have opened Roth IRAs since they were first offered in 1998. Tax-free and no mandatory withdrawals helped feed interest in these retirement savings accounts.
How the Roth 401(k) Works:
Employees who are eligible for their employer’s 401(k) plan also would be eligible for a Roth 401(k). Unlike a Roth IRA, there isn’t an income limitation. However, the amount highly compensated employees can contribute to a Roth 401(k) may be limited if their employer places a similar limit on traditional 401(k) contributions.
Contributions are made with after-tax dollars, whereas contributions to a traditional 401(k) are made with pre-tax dollars. The maximum amount an employee can contribute to a Roth 401(k) is the same as for a traditional 401(k): $18,000 in 2016.
Employees 50 and older can make an additional $6,000 catch-up contribution; for a grand total of $24,000. Contributions can be split between the two types of accounts, and funds will be held separately. However, the contribution limit is for both accounts combined, not individually.
Employers are not required to make any contribution to a Roth 401(k). If your employer does provide matching contributions, those funds will be subject to taxes upon withdrawal in retirement.
The benefit of the Roth 401(k) is that withdrawals are tax-free after age 59½ if the account has been open at least five years. If you leave the company before age 55, withdrawals of earnings would be taxed and generally hit with a 10 percent penalty, unless they’re rolled over into a Roth IRA.
Under current tax law, Roth distributions do not count as income and therefor don't contribute to making Social Security benefits taxable in retirement. Traditional 401 (k) withdrawals are not only taxable but can raise income levels and make Social Security benefits taxable.
Traditional 401(k) accountholders are required to take mandatory minimum withdrawals starting at age 70½. Furthermore, Roth 401(k) payouts are tax-free while payouts from traditional 401(k)s are taxed.
Pros and Cons:
The promise of tax-free withdrawals in retirement would be appealing to mid-career workers who anticipate tax rates will rise in the future and want to shield their retirement income from Uncle Sam.
Workers who earn too much to contribute to a Roth IRA but want tax-free retirement income would benefit from the Roth 401(k), which doesn’t have income limitations. Even with Roth deferral matches are still received, but they are pre-tax match funds just like profit sharing allocations.
Additionally, because Roth accounts are tax free, $1,000 in a Roth is equivalent to saving more than a $1,000 in a traditional IRA. Thus, maximizing Roth 401 (k) contributions is like saving more money than you could with an equivalent amount in a Traditional 401 (k).
Who Should Think Twice?
Near retirement workers who will be retiring soon and will be in a lower tax bracket probably won’t benefit from the Roth 401(k)’s tax-free withdrawals. They would be better off sticking with the traditional 401(k), so they could lower their taxable income while still in a higher tax bracket.
Unsure about Future Tax Bracket
Individuals who don’t know whether they will fall into a lower tax bracket in retirement might want to stick with their traditional 401(k) plan or split their contributions in case they actually stay in a higher tax bracket.