Roth 401(k) Accounts

When planning for retirement, employers can offer a wide variety of investment vehicles. One such vehicle is a Roth 401(k). A Roth 401(k) operates similarly to a traditional 401(k); your employer sponsors the plan, you contribute money to the account, you choose how the money is invested, and you can begin withdrawing the money after you retire. As discussed in greater detail in the next section, the differences between the two accounts revolve around everyone’s favorite five-letter word: “Taxes.”

Roth 401(k) vs. Traditional 401(k)

The main differences between traditional and Roth 401(k) deal with how the money is taxed when contributed and then later withdrawn. Under a traditional 401(k), contributions are made on a pretax basis. This means that while you are not taxed on the money you put into the account, you will pay taxes when the money is withdrawn, including any earnings. On the other hand, contributions to a Roth 401(k) are made using after-tax dollars. Under this arrangement, the contributions are taxed in the same year they are made, but later withdrawals from the account (including any earnings that were not previously taxed) can be tax-free.

When Can I Withdraw Money From a Roth 401(k)?

As discussed in the previous section, withdrawals of contributions and earnings from a Roth 401(k) are not taxed. However, the withdrawals must be “qualified distributions” to be tax-free. Qualified distributions meet the following conditions:

  1. The Roth 401(k) must be held for at least five (5) years prior to the distribution; and
  2. The withdrawal occurred as a result of:
    1. Disability,
    2. Death of the account owner, or
    3. Upon reaching age 59 ½.

If a withdrawal does not meet these criteria, you could owe taxes on the amount withdrawn (including the earnings), in addition to an early withdrawal penalty.

When Do I Have to Begin Withdraw Money From a Roth 401(k)?

Unfortunately, the government will not let you keep your money in your account forever. As is with all employer-sponsored retirement accounts, the IRS requires you to take “required minimum distributions” (RMD) from your account when you reach a certain age. These rules apply to both traditional and Roth 401(k)s (thought Roth IRAs are exempt from the RMD rules). If you do miss your RMD, there is a penalty of 25% of the missed withdrawal’s value. As of January 1, 2023, you are required to begin taking withdrawals from your account either when you retire or reach age 73, whichever is later. See our previous post, New Retirement Plan Laws for 2023 – SECURE Act 2.0, for more information regarding the different applicable required beginning dates.

Key Takeaways

A Roth 401(k) and a traditional 401(k) are similar in almost every respect, except when it comes to taxation. This one difference could have a significant impact on an individual’s personal tax liability and many employees appreciate the trade-off of paying taxes now and withdrawing both the contributions and earnings tax-free later. Moreover, existing 401(k) plans can simply add Roth accounts to their plans as opposed to creating a separate deferred compensation arrangement. However, this is much easier to implement in a single employer setting where you have only one payroll department responsible for the contribution and reporting process. In the multiemployer sector, Trustees and Plan provisions must ensure that each contributing employer understands how these contributions are taxed and reported. In many situations, Roth accounts can only be added to an existing 401(k) plan through the collective bargaining process.  Nevertheless, and despite these additional complications, trustees and union officials should consider whether participants would benefit from either adopting a Roth 401(k) plan or adding a Roth component to an existing plan.