Five Things to Know About Roth 401(k)s
A recent survey found that over 80% of 401(k) plans now offer employees the option of making Roth 401(k) employee contributions. More and more employees are now taking advantage of that opportunity. (In this article, I use the term “Roth 401(k) contributions” to also include Roth employees made to 403(b) and municipal 457(b) plans.) Here are five things to keep in mind about Roth 401(k)s if your plan offers them:
1. They have great tax benefits. Although Roth 401(k) contributions are made with after-tax salary, the contributions grow tax free, and earnings also come out tax free after a five-year holding period is satisfied and after the employee has turned age 59 ½ (or is disabled).
2. They are subject to annual dollar limits. Like pre-tax 401(k) deferrals, Roth 401(k) contributions are subject to an annual dollar limit – for 2024, $23,000 and an additional $7,500 if age 50 or older. However, Roth 401(k) contributions are aggregated with pre-tax deferrals, so you can only make a total of $23,000 (or $30,500) of contributions between pre-tax and Roth.
3. They are not aggregated with IRA or Roth IRA contribution dollar limits. Making a Roth 401(k) contribution has no impact on your ability to make Roth IRA (or traditional IRA) contributions. So, if you’re over age 50 and qualify for both a Roth 401(k) and a Roth IRA contribution, you can make a total 2024 contribution of up to $38,500 ($30,500 + $8,000).
4. They have certain advantages compared with Roth IRAs. If you don’t have the funds to maximize both your Roth 401(k) and Roth IRA contributions, there are several good reasons to fund your Roth 401(k) first. First, Roth 401(k) funds may offer more protection against creditors than Roth IRAs. If the Roth 401(k) is part of an ERISA plan, you have an unlimited shield from creditors’ claims. By contrast, Roth IRAs only give you the creditor protection available in the state where you live, which can be less than ERISA protection. Second, most plans allow employees to borrow against their Roth contributions, but Roth IRA owners can’t borrow against those funds. Third, many 401(k) plans will match Roth 401(k) employee contributions, but your custodian won’t match your Roth IRA. Finally, unlike Roth IRA contributions, Roth 401(k)s have no annual income limits (although the plan may restrict contributions made by highly-paid employees.)
5. They have certain disadvantages compared with Roth IRAs. In some respects, however, Roth IRAs may be a better option. Roth IRAs offer unlimited investment choices, but Roth 401(k)s are limited to the plan’s more limited options. Roth 401(k) accounts usually can’t be touched by employees until they turn age 59 ½ (or leave employment), while Roth IRAs are always available (although earnings may be taxable and subject to penalty). Finally, Roth IRA distributions that don’t meet the conditions for a “qualified distribution” are subject to favorable ordering rules, but non-qualified Roth 401(k) distributions must meet a pro-rata rule that causes a part of the distribution to be taxable.
By Ian Berger, JD
IRA Analyst
Ed Slott and Company, LLC
Christian Cordoba, founder of California Retirement Advisors, has been a member of Ed Slott's Master Elite IRA Advisor Group since 2007.