When do you want to pay taxes on your retirement savings? Now, or later?
When you make pre-tax contributions to a traditional 401(k) plan, you’re choosing the “pay later” route. You pay Uncle Sam later—when you withdraw the money.
Roth 401(k) contributions flip that around from a tax standpoint. You pay taxes on Roth contributions now—before they are deposited into your account. Once you meet certain qualifications, your contributions plus any earnings can be withdrawn tax-free.
Is a Roth 401(k) right for me?
Choosing between a traditional or Roth 401(k) mostly hinges on your current and future tax rate and whether a tax break today might be more beneficial than tax-free income in retirement. If you think your tax rate is going to be higher in retirement, consider the Roth, which lets you pay your taxes at today’s lower rate. If think your tax rate will be lower in retirement, consider a traditional pre-tax 401(k) which gives you a tax deduction on today’s higher rate. The problem with this seemingly simple decision is that it’s difficult, if not impossible, to predict future tax rates or your retirement income level.
Fortunately, it doesn’t have to be an either/or decision. Many people choose to be tax-diversified by funding both types of accounts. This gives you a “best-of-both-worlds” tax planning flexibility today and in retirement.
Here are a few common misconceptions about Roth 401(k)s to help put them in context with traditional pre-tax 401(k) accounts.
- Roth 401(k) withdrawals are always tax-free.
To have tax-free treatment, Roth 401(k) withdrawals must be “qualified.” This generally means you must be at least age 59 1/2 and your Roth 401(k) account must have been open and funded for at least five years.
- Roth 401(k)s work just like Roth IRAs.
The tax treatment is the same for both—your contributions are made after you’ve paid taxes on the money. But to contribute to a Roth IRA, your annual income must be below a certain threshold ($137,000 for single filers in 2019). There are no income limits for Roth 401(k) contributions, which means you may contribute to a Roth 401(k) irrespective of your annual income.
The amount you may contribute each year is very different between the two types of Roth accounts. The maximum annual contribution limit for Roth IRAs in 2019 is $6,000. The maximum limit for Roth 401(k) contributions is the same limit that applies for pre-tax 401(k) contributions—$19,000 a year (for 2019). The $19,000 limit is a combined limit applying to your pre-tax 401(k) and Roth 401(k) contributions on an aggregate basis.
- Roth 401(k)s aren’t subject to required minimum distributions (RMDs) at age 70-1/2.
While Roth IRAs are not subject to RMDs, Roth 401(k) are subject to RMDs, just like pre-tax contributions and earnings, since your Roth 401(k) account is part of a qualified retirement plan. However, you can roll over a Roth 401(k) to a Roth IRA and avoid the RMD rules.
- Roth 401(k) employer matching contributions are also tax-free when withdrawn.
If your employer matches your Roth 401(k) contributions, those matching dollars are made on a pre-tax basis. That means you will owe taxes when you withdraw any matching contributions and earnings on those contributions.
- Since Roth 401(k)s are after-tax contributions, they aren’t subject to a 10% early withdrawal penalty.
Roth 401(k) contributions are, indeed, made with after-tax dollars. But just like pre-tax contributions, Roth 401(k) withdrawals before age 59 1/2 are generally considered “non-qualified” and therefore subject to a 10% early withdrawal penalty (and possibly federal income taxes).
If you are interested in changing your contribution elections in your ABA Retirement Funds Program account, please see your plan administrator. As always, consult with your own tax advisor before deciding which type of 401(k) contribution is right for you.
Neither Voya® nor its affiliated companies or representatives provide tax or legal advice. Please consult a tax adviser or attorney before making a tax-related investment/insurance decision.