If you’re lucky enough to have a Roth 401(k) at work, there’s a good chance that you don’t really understand the features and benefits of that workplace retirement savings account.
Consider: just one-third of some 1,000 Roth 401(k) plan participants surveyed by Cerulli Associates could accurately identify the benefits of investing on an after-tax basis, including the fact that withdrawals in retirement are tax-free.
So, what do some two-thirds of Roth 401(k) plan participants need to know about Roth 401(k) plans?
Different from Roth IRA
Many things are similar but not quite the same when it comes to Roth IRAs and Roth 401(k)s, says Jeremy Portnoff, a certified financial planner with Portnoff Financial. For instance, you can’t contribute to a Roth IRA if you’re married filing jointly and your modified adjusted gross income is greater than $196,000. There is, however, no income limit to contributing to a Roth 401(k), says Sarah Brenner, an analyst with Ed Slott and Co.
Mix and match
If a 401(k) plan has a Roth feature, one can typically contribute some money to the Roth and some to the traditional 401(k), all to the Roth, or all to the traditional. “They can do any amount to the Roth 401(k) versus the pre-tax 401(k) as long as the total between the two doesn’t go over the $18,000, or $24,000 if over age 50, contribution limit,” says Portnoff.
Note, however, that if even you put all of your contributions to the Roth 401(k), any employer contributions will still be pre-tax, says Portnoff.
Pre-tax and after tax
One big difference between the Roth 401(k) and traditional 401(k), according to Terry Prather, a wealth planner with Payne Wealth Partners, is this: Contributions to a Roth 401(k) are made with after-tax dollars while contributions to a traditional 401(k) are made pre-tax. And distributions from a traditional 401(k) are generally taxed as ordinary income, while distributions from a Roth 401(k) are generally tax free.
Of note, having money in both a traditional 401(k) and a Roth 401(k) is one way to create tax-efficient income come retirement. Phillis Sax Pilvinis, a financial adviser with PSP & Associates and author of Creating Calm Amidst the Storm, How to Have Retirement Certainty Even in Uncertain Times. “Most people who have pretax dollars in retirement find themselves paying far more in taxes than they ever thought possible,” she says. “The Roth 401(k) is certainly one way to diffuse the potential tax bomb.”
For his part, Prather says someone who is contributing the maximum to their 401(k) and spending — after paying applicable taxes — the remainder of their employment income can force themselves to save more towards their future by maximizing contributions to a Roth. “They are essentially forcing themselves to spend less today by having a higher tax bill,” he says. “Why? If they retire with $500,000 in a Roth 401(k), that’s a lot more money than if they retired with $500,000 in a traditional 401(k) where the balance will be subject to income tax when withdrawn.”
According to Brenner, the rules for taking tax-free distributions from your Roth IRAs are more favorable than those from your Roth 401(k). “Your five-year period for qualified distributions starts with your first contribution to any Roth IRA,” she says. “For Roth 401(k)s, the five-year period for qualified distributions applies separately to each plan.”
With your Roth IRA, Brenner also notes that special ordering rules say that any earnings will leave the Roth IRA last. “This is good news because it means that the only funds that would be taxed will come out after all your other Roth IRA funds have been distributed,” she says. “With your Roth 401(k) this is not the case. A distribution that is not qualified is subject to the pro-rata rule. This means that a portion of each distribution that is not qualified will be taxed.”
Roth 401(k) loans
According to Carlos Dias Jr., a financial planner with Excel Tax & Wealth Group, Roth 401(k) loans are categorized as either “qualified” (the plan participant is age 59½ or older and has been contributing to the account for five years or more, permanently disabled, or dead) or “non-qualified” (taxes will be paid on the earnings but not the principal).
Roth 401(k) account owners have to take required minimum distributions (RMDs) starting at age 70½. That’s not the case for Roth IRA account owners. Given that, Mary Kusske, founder and president of Kusske Financial Management, says Roth 401(k) account owners should roll their Roth 401(k) to a Roth IRA before they turn 70½. Roth IRA account owners don’t have to take RMDs.
Of note, when executing a rollover, it’s always best to do a direct trustee-to-trustee transfer versus receiving funds directly and using the 60-day rule, says Dias. According to the IRS, If a distribution from an IRA or a retirement plan is paid directly to you, you can deposit all or a portion of it in an IRA or a retirement plan within 60 days. The IRS may waive the 60-day rollover requirement in certain situations if you missed the deadline because of circumstances beyond your control.
Speaking of rolling money from one account to another, Brenner says you can roll over your Roth 401(k) funds to your Roth IRA. “However, you may not roll over your Roth IRA to your Roth 401(k),” she says. “A Roth IRA is the end of the road when it comes to portability between plans.”
Inheriting a Roth 401(k)
Depending on the beneficiary form, Dias says an inherited Roth 401(k) can be similar to a Roth IRA — it can be “stretched” according to the beneficiary’s lifetime. That is, RMDs can be taken based on the beneficiary’s life expectancy and not that of the deceased Roth 401(k) account owner.
Robert Powell is editor of Retirement Weekly, contributes regularly to MarketWatch, The Wall Street Journal, USA TODAY and teaches at Boston University.