How Do Roth 401(k) Plan Contributions Work?
Save After-Tax Dollars With a Roth 401(k)
For decades, 401(k) plans allowed pre-tax (or traditional) contributions. Since 2006, savers have had another option: the Roth 401(k). A Roth 401(k) is a retirement savings plan that lets you contribute after-tax dollars to a separate account in a 401(k) plan designated only for Roth contributions.
The idea is that you can prepay your income taxes today and take tax-free withdrawals in retirement. Understand how Roth 401(k) contributions work to decide whether the account meets your investment goals and preferences.
Roth vs. Traditional 401(k) Contributions
The easiest way to understand how 401(k) contributions work is to compare them to traditional 401(k) contributions.
- Availability: Roth 401(k) contributions have only been permitted since 2006, whereas the traditional variant has been around since 1978. The Roth account is an optional feature, and some employers have chosen not to offer it.
- Contribution dollars: You contribute to a Roth 401(k) with after-tax dollars, whereas traditional 401(k) contributions are made with pre-tax dollars.
- Taxes on contributions: Roth 401(k) contributions don't lower your taxable income in the current year. Traditional contributions reduce your taxable income and overall tax bill, making it easier to afford contributions.
- Taxes on withdrawals: When you take funds out of a Roth 401(k) in retirement, you'll generally be able to do so without paying income taxes. However, that requires you to follow IRS rules, including waiting until age 59.5 and keeping your account open for at least five years. Because traditional 401(k) contributions aren't taxed up front, you'll have to pay income tax on your own contributions plus any earnings over the years.
- Tax deferral: As with traditional accounts, you don’t have to pay taxes on the earnings on your contributions to a Roth 401(k) every year.
Employee vs. Employer Contributions
There are two types of contributions to a 401(k) account. Here's how each of them works:
- Employee: When you direct part of your salary to a 401(k), you’re making “salary deferral” contributions (also known as “employee” contributions). For those contributions, you can choose whether you want to make traditional, Roth, or both types of contributions—up to the total annual limit.
- Employer: Your employer might also contribute to the plan and help you accumulate retirement savings. Those contributions, known as employer contributions, might be matching contributions, profit-sharing, or other types of contributions. While your employer can choose to match your Roth 401(k) contributions, employer contributions are usually pre-tax contributions (they can't be allocated to a Roth account). You'll need to pay tax on withdrawals from pre-tax accounts.
Roth 401(k) Contributions Limits
When you're getting to know how Roth 401(k) contributions work, keep in mind that contributions aren't unlimited. The limits for Roth 401(k) contributions are the same as those for traditional 401(k) contributions. In 2020 and 2021, the maximum you can contribute to a 401(k) (as salary deferral) is $19,500. If you’re over the age of 50, you can make another $6,500 in catch-up contributions, making your limit $26,000. You can direct some or all of your salary to each option as long as you don't exceed your maximum contribution amount.
The overall limit on 401(k) contributions including salary deferrals (but not catch-up contributions), employer contributions, non-elective contributions, and plan forfeitures is $57,000 for 2020 and $58,000 for 2021. That figure rises to $63,500 for 2020 and $64,500 for 2021 with catch-up contributions.
In addition to contributing to a Roth 401(k) out of your salary, you may be able to convert existing pre-tax savings to Roth money in your 401(k) through what is known as an in-plan rollover. To do so, you must pay tax on your pre-tax amount. It’s often wise to fund the tax payment with outside assets instead of your pre-tax money, which could reduce the amount that ends up in your Roth account. Like the Roth option itself, in-plan rollovers are an optional plan feature that some employers choose to offer.
Once you make a Roth 401(k) contribution, you can't recharacterize it as a traditional pre-tax contribution.
Deciding Whether to Work With a Roth 401(k)
While a Roth 401(k) presents another savings option, making Roth contributions may or may not work for you. Speak with your tax preparer or a qualified tax advisor before making your decision.
If you believe that income tax rates will rise in the future, Roth 401(k) contributions might be a good idea because you won't pay tax on the withdrawals. Your taxes could up in at least two ways, although anything is possible:
- Across-the-board tax rate hikes: If legislation results in higher rates, it’s possible that you’d pay taxes at a higher rate, even if your income remains the same.
- Moving up a tax bracket: If your income increases and current laws remain unchanged, a portion of your earnings might be subject to higher income tax rates.
But the traditional assumption is that you’ll be in a lower tax bracket in retirement. You won't be earning income from employment at that stage, and you'll have a relatively small income from Social Security (and maybe a pension). If that holds true, Roth could end up being the wrong move because you’d pay taxes during your highest-earning years. Even then, the decision isn't simple because the type of account you use could affect how much income you show on tax returns, which could impact other areas of your finances.
You never know what will happen, so you'll need to make some assumptions and educated guesses based on how you think your Roth contributions will work in the future—and then live with the consequences. If you’re not confident one way or the other, diversify your savings by making both traditional contributions and Roth contributions. That way, you’ll have the option to pull from whichever account works best for you when you need funds.
Roth 401(k) vs. Roth IRA Contributions
Aggressive savers might want an additional savings vehicle to help grow their nest egg faster, while those who don't need to save as much may want an alternative. The Roth IRA is one such option, and if you know how Roth 401(k) contributions work, you'll have an easier time with Roth IRA contributions since they work similarly.
Both Roth 401(k) plans and Roth IRAs allow for after-tax savings. The key differences between these account types include:
- Maximums: The Roth 401(k) has higher annual savings limits (the IRA maxes out at $6,000 in 2020 and 2021, or $7,000 for people 50 and over). By contributing to a Roth IRA and a 401(k), you can maximize your after-tax savings.
- Income limits: To be eligible for Roth IRA contributions, your income must be below IRS limits. You can only make Roth IRA contributions if you earn less than $139,000 as a single filer in 2020 ($140,000 in 2021) and $206,000 if you're married and filing jointly in 2020 ($208,000 in 2021). But those income levels do not disqualify you from making Roth 401(k) contributions.
- Access: You can generally pull contributions out of a Roth IRA (as opposed to distributions that include earnings on those contributions) at any time without taxes or penalties. Check with your CPA before doing so. However, if you have traditional and Roth contributions in your 401(k), any distributions might require you to take out a proportional share of pre-tax and after-tax money, resulting in potential income taxes and penalties if you withdraw funds early.