What is the difference between a regular 401(k) and Roth 401(k)?
With a traditional 401(k) Plan, contributions are made on a pre-tax basis and contributions reduce taxable income each year, providing a current tax incentive. When the contributions and earnings are withdrawn, the account is subject to income taxes. The Roth 401(k) involves making a 401(k)
contribution on an after-tax basis. In exchange for foregoing an up-front tax deduction, the contribution and earnings can be withdrawn in the future on a tax-free basis.
In order to qualify for tax-free status, withdrawals from the Roth 401(k) account must be considered “qualified,” which consists of two requirements. The first is a “5-year rule”: A participant must wait five years from the start of making Roth 401(k) contributions to qualify for tax-free withdrawal. The 5-year period doesn’t apply to each year’s contributions, only the commencement of Roth 401(k) contributions. Second, the distribution must be for a “qualified purpose,” meaning that the participant must reach age 59 ½, become disabled or die.
How does a Roth 401(k) impact contribution limits?
The limits for traditional 401(k) contributions also apply to Roth 401(k) contributions. Thus, for 2016, the maximum allowable contribution would be $18,000. The Catch-Up contribution rules also apply, so for those age 50 or over, the limit is $24,000. You may split your contribution during the year between traditional 401(k) contributions and Roth 401(k) contributions. However, overall limits shown above do still apply.
Who benefits from a Roth 401(k)?
Whether making Roth 401(k) contributions or traditional 401(k) contributions is best truly comes down to the circumstances and future expectations for each individual. Participants in their 20's, 30's and 40's in particular can accumulate the Roth contribution earnings tax-free over long periods, which is a great advantage. Current and future tax rates should also be considered. We recommend that participants analyze their own tax situation with their advisors.