A Roth 401(k) retirement plan combines some of the most tax-advantageous features of a traditional 401(k) and Roth IRA. In a traditional 401(k) plan, contributions are made on a pre-tax basis. Investments grow tax-free, but the contributions and investment income are both taxed when funds are withdrawn from the account (typically in retirement). In contrast, contributions to a Roth 401(k) plan are made from after-tax income. However, investments grow tax-free, and investment income is never taxed — not even upon withdrawal.
|Plan set by||Employer||Employer|
|Contribution Limits||Employee contribution limit of $18,000 (under 50 yrs old), $24K (50+); limits apply to combined total contributed to 401k and Roth 401k. Employee and employer combined contributions must be lesser of 100% of employee's salary or $53,000.||2018: $18.5K (under 50 yrs old), $24.5K (50+); 2014: $17.5k (under 50), $23K (50+); limits apply to combined total contributed to 401(k) and Roth 401(k). Employee and employer combined contributions must be lesser of 100% of employee's salary or $53K|
|Income Limits||Generally none, but somewhat complicated due to HCE (highly compensated employees) rules||None|
|Employer contributions||Often||No. Some employers offer matching contributions but they must be allocated into a pre-tax account, like a traditional 401(k).|
|Investments in the account||Stocks, Bonds, Mutual Funds. Capital gains, dividends, and interest within account incur no tax liability.||Stocks, Bonds, Mutual Funds. Capital gains, dividends, and interest within account incur no tax liability.|
|Tax Implications||Money is deposited as tax-deferred and grows tax-free in the account. Gains in the account are not taxed. Distributions from the account are considered ordinary income and taxed accordingly. (some exceptions for after-tax contributions where allowed)||Money set aside for Roth 401k is taxed, but once saved in the account, grows tax-free and is not subject to tax at withdrawal.|
|Distributions||Distributions can begin at age 59 1/2 or earlier if owner becomes disabled.||Distributions can begin if 2 conditions are met: (1) the earliest contribution to the account was at least 5 years ago, and (2) owner is over age 59 1/2 or becomes disabled.|
|Forced Distributions||Must start withdrawing funds at age 70 1/2 unless employee is still employed. Penalty is 50% of minimum distribution||Must start withdrawing funds at age 70 1/2 unless employee is still employed.|
|Borrowing against Account||Depending upon the plan, borrowing against funds in the account is allowed up to 50% of the account value but only if still employed with the same employer.||Depending upon the plan, borrowing against funds in the account is allowed up to 50% of the account value but only if still employed with the same employer.|
|Early Withdrawal||10% penalty plus taxes. Early withdrawal restricted to employee contributions; employer contributions cannot be withdrawn early. Exceptions for financial hardships, but 10% penalty applies even in those cases.||No penalties as long as workers don't tap into their investment gains. Tax-free withdrawals for people over age 59 1/2 begin after they've had their account for at least five years|
|Early Withdrawal for Medical Expenses||Medical expenses not covered by insurance for employee, spouse, or dependents subject to 10% penalty||Taxable portion of medical expenses not covered by insurance for employee, spouse, or dependents subject to 10% penalty. At times, the penalty is waived depending on the employer as well as seriousness of the illness.|
|Early Withdrawal for Homebuyers||Purchase of primary residence and avoidance of foreclosure or eviction of primary residence is subject to 10% penalty||Taxable portion of purchase of first home and avoidance of foreclosure or eviction of primary residence is subject to 10% penalty.|
|Early Withdrawal for Educational Expenses||Payment of secondary educational expenses in last 12 months for employee, spouse, or dependents subject to 10% penalty||Taxable portion of payment of secondary educational expenses in last 12 months for employee, spouse, or dependents subject to 10% penalty.|
|Conversions||Upon termination of employment, can be rolled to IRA or Roth IRA. When rolled to a Roth IRA taxes need to be paid during the year of the conversion||Can be rolled to Roth IRA.|
|Withdrawals||Taxed as ordinary income||Not taxed, assuming qualified withdrawals in retirement.|
|Changing Institutions||Can roll over to another employer's 401(k) plan or to an (traditional) IRA at an independent institution||Can rollover to another employer's Roth 401(k) if offered, or to a Roth IRA independently, but not back to a traditional 401(k)|
With company-sponsored 401(k) plans, employees contribute pre-tax funds from their paychecks. Employers sometimes match the contribution up to a certain limit. Contributions to Roth 401(k) plans are funded using post-tax income. Like traditional 401(k), Roth 401(k) plans can also include employer matching, but these employer-funded contributions are treated like a traditional 401(k) i.e., they must be sent to a traditional 401(k) account that is a component of every Roth 401(k) that has employer matching. Also, these funds are subject to tax when they are withdrawn.
A popular sweetener in 401(k) plans is employer matching; businesses often match employee contributions to 401(k) plans as an incentive to participate in the retirement plan. This is essentially "free money" or a bonus for the employee, and it would be unwise not to take advantage of that.
The catch with Roth 401(k) plans is that any matching contributions from the employer must be paid into a traditional 401(k) plan, which will have to be set up in addition to the Roth 401(k). This creates an administrative burden, which many businesses avoid by not offering a Roth 401(k) plan at all.
As of 2015, the maximum yearly contribution that individuals are allowed to make to either 401(k) plan (traditional or Roth) is $18,000 for people under 50, and $24,000 for those over 50 years of age. i.e., workers over the age of 50 are allowed to make "catch-up contributions" of up to $6,000 per year. The corresponding limits for 2014 are $17,500 (under 50) and $23,000 (over 50). Note that these limits are for employee contributions to 401(k), 403(b), most 457 plans, and the federal government’s Thrift Savings Plan. So they apply to both 401(k) and Roth 401(k) plans.
In addition to the limit on employer contribution, the IRS also places limits on total contribution by the employer and employee combined. For 2015, this limit is $53,000 for employees under 50 and $59,000 for employees over the age of 50.
401k contributions are pre-tax, which lowers an employee’s taxable income. However, they are subject to tax when money is withdrawn. This means that they are more advantageous to people who are in higher tax brackets, and expect to remain in the same bracket, or move into a lower bracket, after they retire.
Money put into Roth 401ks is taxed like regular income. However, money saved in Roth 401ks then grows tax free, and is not subject to tax when it is withdrawn. This means that they are most advantageous to people, such as young people, who are in lower tax brackets but expect to be in a higher tax bracket when they retire.
Unlike IRA plans, there are no income limits on the 401(k) or Roth 401(k).
There are disincentives for early withdrawal from any retirement plan: traditional 401(k), IRA, Roth IRA or Roth 401(k). Unless there are mitigating exceptional circumstances (like death, disability, or significant medical expenses), the IRS imposes a 10% penalty on early withdrawal.
But the rules are slightly different for Roth vs. traditional 401(k) plans. First, withdrawals are tax-free only if they begin at least 5 years after the first contribution was made to the plan. Second, a Roth account owners are not penalized for withdrawing money from a plan, provided they avoid withdrawing from any investment gains.
You can start taking money out of a 401k at age 59 & ½, or if the owner becomes disabled. Tax must be paid on these distributions. Owners must start withdrawing at age 70 and a half unless they are still employed. Early withdrawal typically cannot be made while still employed with the employer that set up the 401k. Otherwise, there is a 10% penalty plus tax for early withdrawals.
Distributions from Roth 401ks can begin at age 59 and a half, as long as the account has been open for at least 5 years, or if the owner becomes disabled. Distributions are tax-free.
Owners of 401(k) accounts are required to start taking distributions at the age of 70 ½. There is no such requirement for Roth 401(k) plans.
Roth 401(k) plans offer some advantages at the time of distribution.In particular, distributions from Roth plans are excluded from the formulas that determine Medicare Part B premiums or how much tax is owed on Social Security benefits. In addition, 401(k) plans can be passed to beneficiaries, tax-free.
When changing employers, a 401k can be rolled into an IRA or Roth IRA, or can go into a 401k provided by the new employer.
Roth 401(k) plans cannot be converted to traditional 401(k)s when an individual changes employers, but they can be rolled into Roth IRAs or another employer’s Roth 401k plan.
Traditional vs. Roth 401(k): How to Choose
The choice between Roth 401(k) and traditional 401(k) boils down to taxes. Contributing to a traditional 401(k) plan lowers your tax bill now by deferring taxation to when you retire and withdraw the funds. It is possible that the tax bill in retirement will be much higher because:
- You will be paying taxes on not just the original amount contributed but also all of the investment income in the intervening years.
- Your tax bracket may be higher in retirement than it is now.
So for younger workers who are many decades away from retirement, and whose income is lower because they are just starting their career, Roth 401(k) plans make more sense. They will not lose much in the way of tax-free contributions, and their investment income will be tax-free (and probably large because investments have had a longer time to grow).
Conversely, if you are close to retirement or your income tax bracket is very high, you may be better off choosing a traditional 401(k) plan to contribute into.
The decision to choose a retirement plan can be very taxing, but the lucid explanation in the video below might help one understand the two plans better, and even help decide between the 401(k) and Roth 401(k):
Other Pros and Cons
401k plan choices can be limited and can have higher fees associated with them. However, they can allow savers to borrow from their retirement savings. If hardship withdrawals are included in the plan, payment of secondary education expenses, medical expenses or home down payments, subject to a 10% penalty. Medical expenses that are in excess of 7.5% of a person’s income may be exempt from the penalty.
Not all employers offer Roth 401k plans. Funds cannot be used to fund house down payments, education expenses or medical expenses.