In a 2022 401(k) plan design study of 4,330 small businesses, we found about 78% permit participants to make after-tax Roth contributions to their personal account. I think it’s safe to assume the high adoption rate of this 401(k) plan feature is due to participant demand.
Why do 401(k) participants like Roth contributions? They offer a tax-free nest egg at retirement. To earn this benefit, participants pay taxes on their Roth contributions in the year they are made — at personal income tax rates. This differs from traditional 401(k) salary deferrals, which are tax-deductible in the year they are made - and then tax-deferred until withdrawal.
While Roth 401(k) contributions are popular, they are not for everybody. Because Roth contributions are taxed upfront, participants are often forced to contribute less - reducing the earnings power of these contributions over time. Further, participants that expect lower tax rates in retirement are probably better off making pre-tax salary deferrals.
If your 401(k) plan does not currently include Roth contributions, I think now is a great time to give them a fresh look. Personal income tax rates are at historic lows, making Roth contributions more affordable than ever. In addition, starting in 2024, catch-up contributions for participants making over $145,000 (adjusted annually for inflation) must be Roth contributions. This change may cause reluctant plan sponsors to add Roth contributions soon. You can use this FAQ to help decide if Roth contributions are right for your 401k plan.
Who are the best candidates for making Roth 401(k) contributions?
Generally, 401(k) participants that expect their tax rate to be higher in retirement than it is today are the best candidates for Roth contributions. The ideal candidate is a young worker that expects their income to climb throughout their career and a large – otherwise taxable – nest egg at retirement.
However, high earners with taxable investments can also benefit from Roth contributions. Unlike Roth IRA contributions, there are no income restrictions for making Roth 401(k) contributions. That means high earners can build a large tax-free account over time to hedge against their taxable investments.
That said, nobody has a crystal ball regarding future tax rates. 401(k) participants at all income levels choose to make Roth deferrals to reduce their taxable retirement income.
Who is eligible to make Roth 401(k) contributions?
When a 401(k) plan includes a Roth feature, any 401(k) participant eligible to make pre-tax salary deferrals is also eligible to make Roth contributions. Starting in 2024, catch-up contributions for participants making over $145,000 (adjusted annually for inflation) must be Roth contributions.
What is the Roth 401(k) contribution limit?
Roth contributions are subject to the same IRC Section 402(g) limit that applies to pre-tax salary deferrals. When applying this limit, these contributions are combined. The 402(g) limit is adjusted annually for inflation. For 2023, the Roth 401(k) contribution limit is $22,500, plus an additional $7,500 for 401(k) plans that allow catch-up contributions.
How are Roth 401(k) contributions taxed at withdrawal?
Because Roth contributions are made with after-tax dollars, they're not taxable at withdrawal. Their earnings can also be withdrawn tax-free when they’re part of a qualified distribution. A qualified distribution is one that occurs at least five years after the year of the participant’s first Roth contribution and is made:
- On or after attainment of age 59½,
- On account of disability, or
- On or after the participant’s death
When Roth 401(k) funds are withdrawn as part of a non-qualified distribution, their earnings are taxable at personal income tax rates and may be subject to a 10% early withdrawal penalty.
What is an in-plan Roth 401(k) rollover?
An in-plan Roth rollover, also called an in-plan Roth conversion, is a reclassification of non-Roth 401k funds to Roth funds. Any 401(k) plan that includes a Roth feature can permit in-plan Roth rollovers. 401(k) participants can convert any vested balance, including earnings, to Roth funds.
When a 401(k) participant makes an in-plan Roth rollover, they must report the rollover amount as taxable income for the year of the conversion and pay the tax due. However, these rollovers are not subject to the 10% early withdrawal penalty or mandatory income tax withholding.
Participants are most likely to make in-plan Roth rollovers in tax years where their income is low or their non-Roth account balance has dropped in value.
Are Roth 401(k) accounts subject to the same RMD rules as Roth IRAs?
Beginning in 2024, RMDs from a Roth 401(k) account will be similar to Roth IRS contributions which are not subject to IRS Required Minimum Distribution (RMD) rules until the death of the IRA owner. Until that time, RMDs from a Roth 401k account must commence on April 1 of the year following (whichever occurs last):
- Participant turns 72 or
- Year participant retires
5% owners of the 401(k) plan sponsor must start RMDs by April 1 of the year following when they turn 72.
However, Roth 401(k) account RMDs can be avoided by rolling their dollar amount to a Roth IRA prior to the RMD deadline.
It’s all about the taxes!
Unfortunately, it can be tough for 401(k) participants to decide whether Roth contributions are the right choice for them. The two key deciding factors – future income and tax rates – just aren’t predictable.
However, if your 401(k) plan allows Roth contributions, you owe it to your future self to consider these contributions — especially if these contributions are made even more affordable by lower personal income tax rates.