A Roth 401(k) is an account available in some 401(k) plans that allow participants to make some of their contributions to after-tax accounts. A Roth 401(k) differs from a traditional 401(k) because traditional 401(k) contributions are tax-deductible, Roth 401(k)s contributions are taxed but withdrawals during retirement are tax-free.
How a Roth 401(k) Works
A Roth 401(k) is a retirement account that some companies allow in their 401(k) plan. Using a Roth 401(k), plan participants can put some or all of their allowed contributions in after-tax accounts. While Roth contributions aren’t tax-deductible like traditional 401(k) contributions, Roth 401(k) withdrawals are tax-free after age 59 1/2.
When participants use a Roth 401(k), they make contributions that aren’t taxable. They must still pay taxes on their contributions. However, the contributions they make can grow in their account tax-free and, unlike traditional 401(k) contributions, aren’t taxed when they’re withdrawn after age 59 1/2. This allows participants to lower their potential tax liability during retirement while also letting contributions grow tax-free.
Roth 401(k) vs. 401(k)
A Roth 401(k) is a feature that many employers include in their 401(k) plans. While not every 401(k) has a Roth feature, participants in those plans that have a Roth feature have the option of contributing up to the plan limit ($18,500) to a Roth 401(k) vs. a 401(k) tax-deferred account.
If a plan participant chooses to use part of their annual contributions for a Roth 401(k), those contributions count against their total annual contribution limits ($18,500 for 2018). While Roth 401(k) vs. 401(k) contributions aren’t tax-deductible, traditional 401(k) are. However, Roth 401(k) accounts still grow tax-free and withdrawals after age 59 1/2 aren’t subject to income tax.
Who a Roth 401(k) is Right For
A Roth 401(k) is appropriate for investors who want to reduce their tax liability during retirement. Tax-conscious investors, employees who maximize their traditional 401(k) contributions, and business owners with potential tax liability from selling their business can reduce their future taxes a Roth 401(k) to grow savings that can be withdrawn tax-free.
Roth 401(k)s are ideal for investors seeking to reduce their future tax liability, but traditional 401(k)s offers greater upfront tax benefits. When deciding how much of your contributions to put in a Roth 401(k), consider the tax implications carefully. Read our article on Roth vs. traditional 401(k)s for more information and to discover which one is best for you.
Three reasons why investors should use a Roth 401(k) are:
1. Want Reduced Roth 401(k) Taxes in Retirement
The biggest reason that people use Roth 401(k)s is because of Roth 401(k) taxes. Roth 401(k)s allow participants to make contributions that are not tax-deductible, so they’re still taxed as income. However, once you contribute to a Roth 401(k), contributions grow tax-free and can be withdrawn tax-free after age 59 1/2.
Using traditional 401(k)s, on the other hand, participant contributions are tax-deductible but withdrawals are taxable. This leads some traditional 401(k) participants to use a Roth for some of their 401(k) contributions. They pay taxes on those contributions now, let their account grow tax-free and are able to take Roth 401(k) withdrawals during retirement tax-free.
2. Regularly Maximize Your Employee 401(k) Contributions
Employees who routinely maximize their 401(k) deferrals should consider using a Roth 401(k) for part of their contributions. Employees who have savings in pretax accounts outside their 401(k) may also want to consider a Roth because all of their withdrawals from tax-deferred accounts will be taxed as income later on.
“I set up a Roth 401(k) once I’d maxed out 401(k) contributions and started considering long-term tax planning. Because Roth 401(k) contributions are included in total 401(k) contributions for the year, I base my decision from year-to-year on my tax rate that year and where I think it’ll be in 30 years when I retire. If I think my taxes will be higher in retirement than they will be this tax year, I contribute more to my Roth. If not, I contribute less to my Roth.” — Bryan Gardner, CEO, Coopt
3. Business Owners Offsetting Tax Liability with a Roth 401(k)
Many business owners sell their companies to fund their retirement, which can create considerable tax liability. By using a Roth instead of a tax-deferred 401(k) account, company owners can set aside money that can be withdrawn tax-free to fund part of their retirement before they sell their business.
While Roth 401(k)s can be ideal for certain types of investors, they aren’t appropriate for everyone. If you’re a new investor just starting out, want an upfront tax deduction to increase your tax refund, you may not want to use a Roth 401(k).
Some investors who may not be a good fit for Roth 401(k)s include:
- Newer Investors: If you’re just starting out or newer to investing, you may not want to use a Roth 401(k) right away. Get used to saving and managing your portfolio before deciding if a Roth is right for you.
- Tax-deduction maximizers: Young couples or single investors who maximize their tax deductions each year won’t find much help from Roth 401(k)s. Roth 401(k) contributions aren’t tax-deductible, so you’d be better sticking with a traditional 401(k).
- Small savers: If you don’t contribute more than a couple of thousand dollars per year to your retirement plan, you’re probably better off making tax-deductible contributions to a traditional 401(k) rather than setting up a Roth.
- Ineligible investors: Unfortunately, if you aren’t eligible for a 401(k) through work or your plan doesn’t include a Roth 401(k), then you may not have the option of having an account.
If a Roth 401(k) isn’t right for you, some other accounts that may be better include:
- Roth IRA: If you aren’t eligible for a Roth 401(k) at work or your plan doesn’t include a Roth 401(k), you may be able to set up a Roth IRA on your own. However, you’ll need to meet Roth IRA income limits and may be subject to different contribution requirements if you contribute to another retirement account at work or on your own.
- Traditional IRA: A traditional IRA may be better for you if you’d like to make tax-deductible contributions and aren’t eligible for retirement benefits through your work. If you are eligible for an employer-sponsored plan, you may still be able to use a traditional IRA but with different contribution limits.
- Simplified employee pension IRA: SEP IRAs are great retirement plans for self-employed individuals who want the high contribution limits of a 401(k) without the administration costs. Contributions are discretionary each year and tax-deductible but, if you have employees, you’ll need to fund employee contributions proportional to contributions you make for your own account based on annual compensation.
Roth 401(k) Investment Options
Roth 401(k) investors can choose from all of the investment options that are available as part of their broader 401(k) plan. While most Roth 401(k) investment options include mutual funds and target-date funds, other plans allow participants to invest in ETFs or even individual stocks and bonds.
Some Roth 401(k) investment options typically include:
- Mutual funds: Baskets of stocks and bonds that are professionally managed
- Target date funds: Mutual funds that shift from stocks to bonds as a target retirement date approaches
- Exchange-traded funds: Baskets of securities that are structured like mutual funds but trade like stocks
- Stocks: Shares of ownership in companies
- Bonds: Debt issued by companies or countries
Roth 401(k) Costs
The costs of a Roth 401(k) are similar to those of a traditional 401(k) plan and include plan administration, recordkeeping and custodial fees. However, there may be slightly higher recordkeeping or administration fees for a Roth 401(k) because there may be more accounts if participants use traditional and Roth 401(k)s.
Roth 401(k) costs include:
- Plan administration fee: 0.25% – 2.5% annually
Each year a fee for administering a 401(k) is paid out of plan assets. This fee covers recordkeeping, compliance testing and filing the annual Form 5500. The fee is often structured on a per-plan rate plus a per-participant charge.
- Custodian fee: less than 0.25% of plan assets annually
The financial institution that holds participant accounts often charges a fee that’s either fixed or based on plan assets but shouldn’t exceed 0.25 percent of total plan assets. Custodian fees may also be included in other fees or credited against investment fees.
- Advisor fee: 0.5% – 1.5% of plan assets annually
Some plan sponsors engage a financial advisor to advise the plan and plan participants. Advisors usually base their fee on plan assets and charges anywhere from 0.5 percent to 1.5 percent per year. Their fee is also sometimes partially paid from investment fees.
- Investment Fees: 0.25% – 2% of plan assets
Each investment option used in a 401(k) plan charges a small annual fee which is automatically deducted as part of its expense ratios. Depending on the plan and plan providers, these fees may be used to offset other costs.
- Taxes: 10% – 25%
Roth 401(k) contributions are not tax-deductible to plan participants, who will still have to pay income tax on any money they contribute to a Roth 401(k) account.
Roth 401(k) Contribution Limits 2018
Roth 401(k) participants can contribute up to $18,500 to their Roth in 2018. Investors over age 50 are also allowed $6,000 in catch-up contributions. However, it’s important to understand that these contribution limits aren’t separate from traditional 401(k) contribution limits — investors have $18,500 total traditional and Roth 401(k) contribution limit.
This is one of the most misunderstood things about Roth IRA and 401(k) contribution limits — that you can’t maximize contributions to a traditional IRA or 401(k), and then make additional contributions to a Roth account. You can contribute up to $18,500 to a 401(k) in 2018, and how you divide those contributions between traditional and Roth accounts is up to you.
Roth 401(k) Contribution Limits
“Because it comes right out of your paycheck, a Roth contribution is likely to reduce your take-home pay by more than a similar contribution to a traditional 401(k), which is made using pretax dollars. If you want to save — and take home as much money as possible — a traditional 401(k) is perhaps the better option. In many cases, it is often possible to contribute to both a Roth 401(k) and a traditional 401(k). Since no one knows what tax rates will be in the future, diversifying with contributions to both a traditional and a Roth 401(k) might be a way to hedge your tax bets with your retirement savings.” — Gerri Walsh, Senior Vice President for Investor Education, FINRA
Roth 401(k) Rules
There several rules that you need to follow to set up or use a Roth 401(k) within your 401(k) plan. To use a Roth, be sure to follow applicable tax rules, make only allowable investments, meet required age limits and take RMDs in addition to following Roth 401(k) deadlines.
Five of the primary Roth 401(k) rules are:
- Don’t deduct Roth 401(k) contributions: Unlike traditional 401(k) contributions, all contributions to a Roth 401(k) account are after-tax. This means that any employee contributions to Roth accounts can’t be deducted from their taxable income. Instead, Roth 401(k)s grow tax-free, and there are no income taxes when plan participants take withdrawals during retirement.
- Follow Roth 401(k) contribution deadlines: If you’re going to participate in a Roth 401(k) be sure that you follow all Roth 401(k) deadlines. This means making all of your employee deferrals are made before the end of the year and any employer matching contributions are in before the employer’s tax-filing deadline.
- Follow Roth 401(k) investment options: Roth 401(k) accounts are limited to the same investment options as the rest of the plan. Even if your 401(k) has a brokerage option that allows participants to invest in more than a select group of mutual funds or target-date funds, plan participants need to invest in eligible assets like stocks, bonds and ETFs.
- Take only qualified Roth 401(k) distributions: Roth 401(k) participants who wait until age 59 1/2 and hold their Roth accounts for at least 5 years are not taxed when they take withdrawals. This is because they paid income taxes on their contributions when they’re deposited in a Roth, unlike traditional 401(k) accounts that have tax-deductible contributions and taxable withdrawals.
- Meet Roth 401(k) required minimum distributions: While Roth IRAs do not have required minimum distributions, RMDs apply for Roth 401(k)s unless the account holder is still working and not a 5 percent owner of the company that sponsors their 401(k) plan.
Roth 401(k) Deadlines
In addition to following applicable Roth 401(k) rules, it’s important for both plan sponsors and participants to follow Roth deadlines. Because Roth 401(k)s are a feature of traditional 401(k) plans, these deadlines do not differ from normal 401(k) deadlines.
Four Roth 401(k) deadlines include:
- Notify Roth 401(k) eligible employees: When you set up a 401(k) plan you need to provide notice to employees who are eligible. Similarly, any new employees who become eligible for your plan must be given information on the plan including providers, any company match, investment options within the plan and the enrollment process.
- Allow employees to enroll when eligible: Whenever employees become eligible for a 401(k) plan the must be allowed to enroll, even if it’s in the middle of the plan year. Employees must be given the ability to set up traditional and/or Roth 401(k) accounts if they choose.
- Defer Roth 401(k) contributions by year’s end: To comply with Roth 401(k) rules it’s important that once employees are enrolled, all employee deferrals to either traditional or Roth accounts need to be made before the end of the year.
- Make employer matching contributions by tax filing deadline: While employee contributions must be made by year’s end, employer matching or profit-sharing contributions must be made before the employer’s tax filing deadline.
Roth 401(k) Providers
If you want to give 401(k) participants the ability to have Roth accounts within their 401(k), there are several Roth 401(k) providers who can help you include this feature in your plan. Some of these providers are among our Best 401(k) Companies and worth considering.
Some top Roth 401(k) providers include:
Wells Fargo is out best overall 401(k) company for employers who want a full-service provider. In addition to traditional 401(k)s and other types of retirement accounts, Wells Fargo offers 401(k) plans with Roth features and a host of additional banking and brokerage services.
Wells Fargo is an ideal provider if you’re looking for a 401(k) company that’s also a one-stop-shop for all of your business financing needs. Wells Fargo can help you with retirement planning, business banking, lending and even credit cards.
Spark 401(k) from Capital One is an excellent provider of 401(k) plans and 401(k) Safe Harbor Plans. In addition to employer-only 401(k)s, Spark 401(k) also provides 401(k) plans for businesses with employees and gives employers the option to include a Roth 401(k) as part of their plan.
Spark 401(k) is a great 401(k) provider if you’re looking for a simple, cost-efficient offering. Spark’s fees are transparent and minimal, and it offers a menu of options to choose from so you can easily set up the right plan for your business.
Human Interest is a relatively new company that’s disrupting the 401(k) administration space. Although it’s best known for providing Safe Harbor 401(k)s, Human Interest also offers other types of retirement plans including Roth 401(k)s.
If you want to save money on your 401(k) plan administration and are comfortable using technology to administer your plan, you should check out Human Interest. It’s an extremely efficient company that leverages technology to generate big cost savings for small business owners.
Fidelity is one of the largest financial services companies in the world. In addition to securities brokerage and investment advisory services, Fidelity also offers retail banking services to businesses and individuals.
If you already have an account with Fidelity or want another option to Wells Fargo for a full-service firm, Fidelity is a 401(k) provider to consider. It offers a number of different retirement plans including traditional and Roth 401(k)s with access to a ton of different investment options.
Merrill Edge is another great option for a full-service firm that can help business owners save money on retirement planning. Although Merrill Edge is limited mostly to securities brokerage and retirement planning products, the company is a subsidiary of Bank of America, so customers have access to a host of additional banking services.
Merrill Edge is a great provider to consider if you already work with Bank of America or Merrill Lynch, or if you’d like to have access to a dedicated financial advisor to help with your 401(k). Merrill Edge is also helpful if you have accounts separate from your 401(k) that you’d like help managing.
How to Add a Roth to Your 401(k) Plan in 5 Steps
There are several steps that employers and employees must follow to use a Roth 401(k). If you’re an employee and want a Roth, you need to confirm that it’s available in your plan, enroll when you’re eligible and contribute. If you’re a small business owner and want to add a Roth to your plan, there are additional steps you need to follow.
The five steps for how to set up a Roth 401(k) include:
1. Identify a Roth 401(k) Provider
If you’re a small business owner wanting to set up a Roth 401(k) for your employees, the first step is to find a 401(k) company that’s right for you. Research 401(k) providers and compare them on cost, investment options and customer service. Be sure that they offer a Roth feature if you want this included in your plan.
2. Set Up a 401(k) Plan with a Roth 401(k) Feature
Once you’ve decided on a 401(k) company, you have to establish your 401(k) formally. This means adopting plan documents that will govern your plan and describe any matching you intend to provide. In these plan documents, make sure that you include the availability of a Roth as part of your plan.
3. Provide Notice to Eligible Employees
After a business owner has set up their Roth 401(k), they need to provide disclosures to employees who are eligible to participate. Make sure that the notice you provide makes them aware of the Roth feature in the plan. As new employees become eligible, make sure that they’re also given appropriate, timely notice.
4. Enroll Employees in the Plan
If you’re a small business owner, once employees become eligible for your Roth 401(k) you need to give them a chance to enroll. If you’re a plan participant, this is where you’re given the chance to establish your account, choose how much to contribute and select your investment options.
5. Make Contributions & Administer Your Plan
Once a Roth 401(k) is established and plan participants have established their accounts, the last step is to handle ongoing plan administration. For employees, this means continuing to contribute and changing your investment options when necessary. For employers, it means facilitating employee deferrals and making any matching contributions outlined in your plan document.
In addition to facilitating contributions, employers also need to stay on top of plan administration including filing your annual Form 5500. Conduct annual 401(k) nondiscrimination testing including ADP & ACP testing as well as top-heavy testing and correct any plan deficiencies as they arise.
One way to exempt your plan from annual compliance testing is to use a Safe Harbor 401(k). You can still use a Roth 401(k) feature within a Safe Harbor plan but, by meeting certain required matching criteria, you can eliminate 401(k) nondiscrimination testing and allow highly compensated employees including company owners to maximize their contributions.
If you think a Safe Harbor 401(k) plan may be a good idea for your business, we recommend working with Human Interest. Human Interest is a very cost-effective provider of 401(k) plans and specializes in Safe Harbor 401(k)s. To get more information on their offerings or pricing structure, be sure to visit their website.
Roth 401(k) Taxes
Roth 401(k) taxes differ significantly from taxes for traditional 401(k)s and IRAs. Most retirement accounts offer tax-deferred contributions and tax-deferred investing, but withdrawals after age 59 1/2 are taxed as ordinary income. In Roth 401(k)s, on the other hand, contributions are taxed as ordinary income, but account growth and withdrawals are tax-free.
Because of Roth 401(k) taxes, many investors use Roths to reduce their tax burden during retirement. By paying taxes on contributions upfront, investors can front-load their taxes and withdraw money tax-free after age 59 1/2. Although not many use Roth 401(k) accounts exclusively, investors can still lower their overall tax liability by using Roth 401(k)s in conjunction with traditional 401(k)s or IRAs.
Traditional vs. Roth 401(k) Taxes
|Gross Distribution in Retirement|
|Net Withdrawal After-tax|
Pros & Cons of a Roth 401(k)
There are several pros and cons of a Roth 401(k) that should be considered by both business owners and plan participants. Before adding a Roth feature to a 401(k) or diverting part of your allowable 401(k) contributions to a Roth account, be sure to consider all benefits and drawbacks.
Pros of a Roth 401(k)
The biggest Roth 401(k) benefit is the ability to make contributions that grow tax-free and can be withdrawn tax-free after age 59 1/2. There are also many other benefits, which could all tip the scale in deciding whether a Roth is right for you.
Some pros of a Roth 401(k) include:
- Tax-free growth: A Roth 401(k) account grows tax-free over time
- Tax-free withdrawals: Unlike tax-deferred accounts like a traditional 401(k), there’s no income tax owed on Roth 401(k) distributions
- Higher contribution limits than Roth IRA: Contribution limits for a Roth 401(k) are $18,500 compared to the $5,500 for Roth IRAs
- Lending facility: Many 401(k) plans allow participants to borrow against assets in their 401(k) including a Roth 401(k)
Cons of a Roth 401(k)
The biggest disadvantage of a Roth 401(k) is that contributions are not tax-deductible. However, there are several other drawbacks that must be weighed against Roth 401(k) benefits when deciding whether to use a Roth.
Some of the cons of a Roth 401(k) include:
- After-tax contributions: Unlike traditional 401(k)s and other tax-deferred accounts, contributions to Roth 401(k)s aren’t tax-deductible
- Contributions count against total allowable for 401(k): Traditional and Roth 401(k) contributions are limited to $18,500, so all contributions you make to a Roth 401(k) count against the $18,500 total
- Potentially higher plan administration fee: The administration fee may be slightly higher for a 401(k) with a Roth feature
- No withdrawals until age 59 1/2: You can’t take withdrawals from a Roth account until age 59 1/2 without facing a 10 percent penalty
- Required minimum distributions: Unlike a Roth IRA, Roth 401(k) accounts are subject to normal required minimum distributions starting at age 70 1/2
Roth 401(k) vs. Roth IRA
A Roth IRA is an account that can be established by anyone who qualifies. It’s not part of an employer-sponsored retirement plan. Anyone who meets Roth IRA income limits can make Roth IRA contributions up to $5,500 per year. However, Roth IRA contributions count against your total allowable IRA contributions for the year.
If you don’t have a Roth available through your 401(k) plan, you may be able to set up a Roth IRA on your own. However, there are several differences between a Roth 401(k) vs. Roth IRA. Roth 401(k) contribution limits are considerably higher than Roth IRA contribution limits. Roth IRAs are also subject to income limits, which may restrict your ability to contribute.
However, Roth IRA account holders do not have required minimum distributions starting at age 70 1/2 like with Roth 401(k)s and other types of retirement plans. Also, unlike a Roth 401(k), Roth IRAs aren’t employer-sponsored retirement plans. Anyone who qualifies and wants to contribute can be set up an account on their own.
Roth 401(k) vs. Roth IRA Contribution Limits
For Account Holders Age 50+
Participants in 401(k) plans that have a Roth feature can contribute up to the plan limit to a Roth, which is $18,500 for 2018. The contribution limit for individuals who qualify and set up a Roth IRA on their own is considerably lower at just $5,500.
Roth 401(k) Frequently Asked Questions (FAQ)
If you still have questions after reading this article, here are some of the most frequently asked questions about Roth 401(k)s. If you still have questions after reading the answers below, feel free to join the discussion in the comment section below or visit the FitSmallBusiness Forum and post your question there.
Are There Roth 401(k) Income Limits?
Roth 401(k)s don’t have income limits that restrict eligibility. Anyone who has a Roth 401(k) through their 401(k) at work can contribute. This is different for a Roth 401(k) vs. Roth IRA — Roth IRA account holders must meet Roth IRA income limits to contribute, but there aren’t Roth 401(k) income limits.
What are Roth 401(k) Rules for Early Withdrawals?
Roth 401(k) rules require that a 10 percent penalty be assessed on any withdrawals taken before age 59 1/2 or before you’ve had your account for 5 years. This is the same penalty that’s assessed for traditional 401(k)s and other IRAs. However, Roth 401(k) early withdrawals still aren’t taxable.
Do Companies Match Roth 401(k) Contributions?
If your company provides 401(k) matching, that matching is also provided for any Roth 401(k) contributions in addition to traditional 401(k) contributions. However, while employee Roth 401(k) contributions are after-tax, employer contributions are pretax. This means that employer contributions will still be taxed when withdrawn in retirement.
Can You Convert a Roth 401(k) to a Roth IRA?
If you’ve separated from employment and are eligible for an IRA rollover, you can convert a Roth 401(k) to a Roth IRA using the same 60-day rollover process that’s used for moving money from a traditional 401(k) into an IRA. However, most people use direct transfers to move money from one custodian to another.
The Bottom Line
A Roth 401(k) is a feature that some employers include in their 401(k) plan. Roth 401(k)s allow plan participants use some or all of their contributions for Roth accounts rather than traditional 401(k)s. Roth contributions aren’t tax-deductible but grow tax-free and can be withdrawn tax-free during retirement.
If you want to offer a Roth 401(k) for your small business, reach out to Human Interest. Human Interest is a 401(k) company that makes it easy and cost-effective to include Roth 401(k) accounts in your 401(k) plan. Its plan administration service also helps to ensure your 401(k) doesn’t violate 401(k) nondiscrimination tests.