Roth 401(k)

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The Roth 401(k) is a type of retirement savings plan. It was authorized by the United States Congress under the Internal Revenue Code, section 402A, [1] and represents a unique combination of features of the Roth IRA and a traditional 401(k) plan. Since January 1, 2006, U.S. employers have been allowed to amend their 401(k) plan document to allow employees to elect Roth IRA type tax treatment for a portion or all of their retirement plan contributions. The same change in law allowed Roth IRA type contributions to 403(b) retirement plans. The Roth retirement plan provision was enacted as a provision of the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA 2001).

Contents

Traditional 401(k) plan

In a traditional 401(k) plan, introduced by Congress in 1978, employees contribute pre-tax earnings to their retirement plan, also called "elective deferrals". That is, an employee's elective deferral funds are set aside by the employer in a special account where the funds are allowed to be invested in various options made available in the plan. The IRS sets a limit on the amount of funds deferred in this way, and includes a "catch up" provision intended to allow older workers to save for their approaching retirement. These limits are adjusted each year to reflect changes in the cost of living due to inflation. For tax-year 2019, this limit is $19,500 for those under age 50, and $26,000 for those 50 and over. [2]

Employers may also add funds to the account by contributing matching funds on a fractional formula basis (e.g., matching funds might be added at the rate of 50% of employees' elective deferrals), or on a set percentage basis. Funds within the 401(k) account grow on a tax deferred basis. When the account owner reaches the age of 59½, he or she may begin to receive "qualified distributions" from the funds in the account; these distributions are then taxed at ordinary income tax rates. Exceptions exist to allow distribution of funds before 59½, such as "substantially equal periodic payments", disability, and separation from service after the age of 55, as outlined under IRS Code section 72(t).

Roth IRA

Under a Roth IRA, first enacted in 1998, individuals, whether employees or self-employed, voluntarily contribute post-tax funds to an individual retirement arrangement (IRA). In contrast to the 401(k) plan, the Roth plan requires post-tax contributions, but allows for tax free growth and distribution, provided the contributions have been invested for at least 5 years and the account owner has reached age 59½. Roth IRA contribution limits are significantly lower than 401(k) contribution limits. For tax years 2016 and 2017, individuals could contribute no more than $5,500 per year to a Roth IRA if under age 50, and $6,500 if age 50 or older. For tax years 2019, 2020, and 2021, contributions up to $6,000 are permitted under age 50, or $7,000 if 50 or older. [2] [3] Additionally, Roth IRA contribution limits are reduced for taxpayers with a Modified Adjusted Gross Income (modified AGI) greater than $125,000 ($198,000 for married filing jointly), phasing out entirely for individuals with a modified AGI of $140,000 ($208,000 for married filing jointly), for 2021. [2] See 401(k) versus IRA matrix that compares various types of IRAs with various types of 401(k)s.

Roth 401(k) plans

The Roth 401(k) combines some of the most advantageous aspects of both the 401(k) and the Roth IRA. Under the Roth 401(k), employees may contribute funds on a post-tax elective deferral basis, in addition to or instead of pre-tax elective deferrals under their traditional 401(k) plans. An employee's combined elective deferrals whether to a traditional 401(k), a Roth 401(k), or both cannot exceed the IRS limits for deferral of the traditional 401(k). Employers' matching funds are not included in the elective deferral cap but are considered for the maximum section 415 limit, which is $58,000 for 2021, or $64,500 for those age 50 and older. [4] The higher section 415 limit also applies to after tax contributions, which, depending on the specific 401(k), might be convertible into a Roth 401(k) later. [5]

Employers are permitted to make matching contributions on employees' designated Roth contributions. However, employers' contributions cannot receive the Roth tax treatment. The matching contributions made on account of designated Roth contributions must be allocated to a pre-tax account, just as matching contributions are on traditional, pre-tax elective contributions. (Pub 4530)

In general, the difference between a Roth 401(k) and a traditional 401(k) is that income contributed to the Roth version is taxable in the year it is earned, but income contributed to the traditional version is taxable in the year in which it is distributed from the account. Furthermore, earnings on the traditional version are taxable income in the year they are distributed, but earnings on the Roth version are never taxable.

There are restrictions on the nontaxability of Roth earnings: typically, the distribution must be made at least 5 years after the first Roth contribution and after the recipient is age 59 ½.

A Roth 401(k) plan is probably most advantageous to those who might otherwise choose a Roth IRA, such as younger workers who are currently taxed in a lower tax bracket but expect to be taxed in a higher bracket upon reaching retirement age. Higher-income workers may prefer a traditional 401(k) plan because they are currently taxed in a higher tax bracket but would expect to be taxed at a lower rate in retirement; also, those near the Roth IRA income limits may prefer a traditional 401(k) since its pre-tax contributions lowers Modified Adjusted Gross Income (MAGI) and thus increases eligibility for various other tax incentives (Roth IRA contributions, the Child Tax Credit, medical expense deduction, etc.). Another consideration for those currently in higher tax brackets is the future of income tax rates in the US: if income tax rates increase, current taxation would be desirable for a wider group). The Roth 401(k) offers the advantage of tax free distribution but is not constrained by the same income limitations. For example, in tax year 2013, normal Roth IRA contributions are limited to $5,500 ($6,500 if age 50 or older); up to $17,500 could be contributed to a Roth 401(k) account if no other elective deferrals were taken for the tax year, such as traditional 401(k) deferrals.

Adoption of Roth 401(k) plans has been relatively slow, partly because they require additional administrative recordkeeping and payroll processing. [6] However some larger firms have now adopted Roth 401(k) plans, which is expected to spur their adoption by other firms including smaller ones. [7] IRS Raises 2022 401(k) Contribution Limit to $20,500, [8] a $1,000 boost from 2021 contribution limits. [9]

Additional considerations

See also

Related Research Articles

In the United States, a 401(k) plan is an employer-sponsored, defined-contribution, personal pension (savings) account, as defined in subsection 401(k) of the U.S. Internal Revenue Code. Periodical employee contributions come directly out of their paychecks, and may be matched by the employer. This legal option is what makes 401(k) plans attractive to employees, and many employers offer this option to their (full-time) workers.

An individual retirement account (IRA) in the United States is a form of pension provided by many financial institutions that provides tax advantages for retirement savings. It is a trust that holds investment assets purchased with a taxpayer's earned income for the taxpayer's eventual benefit in old age. An individual retirement account is a type of individual retirement arrangement as described in IRS Publication 590, Individual Retirement Arrangements (IRAs). Other arrangements include employer-established benefit trusts and individual retirement annuities, by which a taxpayer purchases an annuity contract or an endowment contract from a life insurance company.

A Roth IRA is an individual retirement account (IRA) under United States law that is generally not taxed upon distribution, provided certain conditions are met. The principal difference between Roth IRAs and most other tax-advantaged retirement plans is that rather than granting a tax reduction for contributions to the retirement plan, qualified withdrawals from the Roth IRA plan are tax-free, and growth in the account is tax-free.

<span class="mw-page-title-main">Economic Growth and Tax Relief Reconciliation Act of 2001</span> The "EGTRRA"

The Economic Growth and Tax Relief Reconciliation Act of 2001 was a major piece of tax legislation passed by the 107th United States Congress and signed by President George W. Bush. It is also known by its abbreviation EGTRRA, and is often referred to as one of the two "Bush tax cuts".

In the United States, a 403(b) plan is a U.S. tax-advantaged retirement savings plan available for public education organizations, some non-profit employers (only Internal Revenue Code 501(c)(3) organizations), cooperative hospital service organizations, and self-employed ministers in the United States. It has tax treatment similar to a 401(k) plan, especially after the Economic Growth and Tax Relief Reconciliation Act of 2001. Both plans also require that distributions start at age 72 (according to the rules updated in 2020), known as Required Minimum Distributions (RMDs). Distributions are typically taxed as ordinary income.

A health savings account (HSA) is a tax-advantaged medical savings account available to taxpayers in the United States who are enrolled in a high-deductible health plan (HDHP). The funds contributed to an account are not subject to federal income tax at the time of deposit. Unlike a flexible spending account (FSA), HSA funds roll over and accumulate year to year if they are not spent. HSAs are owned by the individual, which differentiates them from company-owned Health Reimbursement Arrangements (HRA) that are an alternate tax-deductible source of funds paired with either high-deductible health plans or standard health plans.

The 457 plan is a type of nonqualified, tax advantaged deferred-compensation retirement plan that is available for governmental and certain nongovernmental employers in the United States. The employer provides the plan and the employee defers compensation into it on a pretax or after-tax (Roth) basis. For the most part, the plan operates similarly to a 401(k) or 403(b) plan with which most people in the US are familiar. The key difference is that unlike with a 401(k) plan, it has no 10% penalty for withdrawal before the age of 55. These 457 plans can also allow independent contractors to participate in the plan, where 401(k) and 403(b) plans cannot.

<span class="mw-page-title-main">Retirement plans in the United States</span>

A retirement plan is a financial arrangement designed to replace employment income upon retirement. These plans may be set up by employers, insurance companies, trade unions, the government, or other institutions. Congress has expressed a desire to encourage responsible retirement planning by granting favorable tax treatment to a wide variety of plans. Federal tax aspects of retirement plans in the United States are based on provisions of the Internal Revenue Code and the plans are regulated by the Department of Labor under the provisions of the Employee Retirement Income Security Act (ERISA).

A Savings Incentive Match Plan for Employees Individual Retirement Account, commonly known by the abbreviation "SIMPLE IRA", is a type of tax-deferred employer-provided retirement plan in the United States that allows employees to set aside money and invest it to grow for retirement. Specifically, it is a type of Individual Retirement Account (IRA) that is set up as an employer-provided plan. It is an employer sponsored plan, like better-known plans such as the 401(k) and 403(b), but offers simpler and less costly administration rules, as it is subject to ERISA and its associated regulations. Like a 401(k) plan, the SIMPLE IRA can be funded with pre-tax salary contributions, but those contributions are still subject to Social Security, Medicare, and Federal Unemployment Tax Act taxes. Contribution limits for SIMPLE plans are lower than for most other types of employer-provided retirement plans as compared to conventional defined contribution plans like Section 402(g), 401(k), 401(a), and 403(b) plans.

<span class="mw-page-title-main">Thrift Savings Plan</span> Retirement plan for U.S. federal government employees and uniformed service members

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A Simplified Employee Pension Individual Retirement Arrangement is a variation of the Individual Retirement Account used in the United States. SEP IRAs are adopted by business owners to provide retirement benefits for themselves and their employees. There are no significant administration costs for a self-employed person with no employees. If the self-employed person does have employees, all employees must receive the same benefits under a SEP plan. Since SEP-IRAs are a type of IRA, funds can be invested the same way as most other IRAs.

A traditional IRA is an individual retirement arrangement (IRA), established in the United States by the Employee Retirement Income Security Act of 1974 (ERISA). Normal IRAs also existed before ERISA.

Deferred compensation is an arrangement in which a portion of an employee's income is paid out at a later date after which the income was earned. Examples of deferred compensation include pensions, retirement plans, and employee stock options. The primary benefit of most deferred compensation is the deferral of tax to the date(s) at which the employee receives the income.

<span class="mw-page-title-main">Keogh plan</span> Type of pension plan in the U.S

Keogh plans are a type of retirement plan for self-employed people and small businesses in the United States.

<span class="mw-page-title-main">Defined contribution plan</span> Type of retirement plan

A defined contribution (DC) plan is a type of retirement plan in which the employer, employee or both make contributions on a regular basis. Individual accounts are set up for participants and benefits are based on the amounts credited to these accounts plus any investment earnings on the money in the account. In defined contribution plans, future benefits fluctuate on the basis of investment earnings. The most common type of defined contribution plan is a savings and thrift plan. Under this type of plan, the employee contributes a predetermined portion of his or her earnings to an individual account, all or part of which is matched by the employer.

This is a comparison between 401(k), Roth 401(k), and Traditional Individual Retirement Account and Roth Individual Retirement Account accounts, four different types of retirement savings vehicles that are common in the United States.

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In the United States, an employer matching program is an employer's potential payment to their 401(k) plan that depends on participating employees' contribution to the plan.

A Solo 401(k) (also known as a Self Employed 401(k) or Individual 401(k)) is a 401(k) qualified retirement plan for Americans that was designed specifically for employers with no full-time employees other than the business owner(s) and their spouse(s). The general 401(k) plan gives employees an incentive to save for retirement by allowing them to designate funds as 401(k) funds and thus not have to pay taxes on them until the employee reaches retirement age. In this plan, both the employee and his/her employer may make contributions to the plan. The Solo 401(k) is unique because it only covers the business owner(s) and their spouse(s), thus, not subjecting the 401(k) plan to the complex ERISA (Employee Retirement Income Security Act of 1974) rules, which sets minimum standards for employer pension plans with non-owner employees. Self-employed workers who qualify for the Solo 401(k) can receive the same tax benefits as in a general 401(k) plan, but without the employer being subject to the complexities of ERISA.

<span class="mw-page-title-main">SECURE Act</span> 2019 United States federal legislation

The Setting Every Community Up for Retirement Enhancement (SECURE) Act of 2019, Pub. L. 116–94 (text)(PDF), was signed into law by President Donald Trump on December 20, 2019 as part of the Further Consolidated Appropriations Act, 2020.

References

  1. ↑ 26 U.S. Code § 402A - Optional treatment of elective deferrals as Roth contributions
  2. 1 2 3 "Income ranges for determining IRA eligibility change for 2021". IRS. October 26, 2020. Retrieved February 21, 2021.
  3. ↑ IRA Contribution Limits
  4. ↑ "Retirement Topics - 401(k) and Profit-Sharing Plan Contribution Limits". IRS. November 10, 2020. Retrieved February 21, 2021.
  5. ↑ Benz, Christine (February 1, 2015). "Should You Make Aftertax Contributions to Your 401(k)?". Morningstar. Retrieved July 27, 2016.
  6. ↑ Wait-and-see stance for Roth 401(k), Andrea Coombes 2005
  7. ↑ A New Type of 401(k) Picks Up Steam, Jeff D. Opdyke 2006
  8. ↑ "401K Contribution Limits 2022 [Updated] - Upsers Emp" . Retrieved 2021-12-21.
  9. ↑ "IRS Raises 2022 401(k) Contribution Limit to $20,500". Investopedia. Retrieved 2021-12-21.
  10. ↑ "Secure Act 2.0 - What the new legislation could mean for you". Fidelity Viewpoints. April 11, 2023. Retrieved 2023-06-16.
  11. ↑ Maestro, Ryan (9 February 2020). "Lifecycle Tax Arbitrage". WantFI. Retrieved 2021-05-20.
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