Key Points

• Roth 401(k) plans are offered as part of some employer-sponsored qualified retirement plans as a way to invest after-tax dollars, thereby allowing your earnings and future withdrawals to grow tax free.

• The Roth 401(k) does not have income restrictions, making it ideal for people who’ve been phased out of contributing to a Roth IRA.

• Holding on to the account for at least 5 years is required before you can make a qualified distribution.

You may have heard of a Roth 401(k). While they’re not new, they've become increasingly popular. Is it a good idea to have a Roth 401(k)? Understanding what it is and how it differs from the traditional 401(k) can help determine whether this choice should be made.

How Does a Roth 401(k) Compare to a Traditional 401(k)?

Many employers offer individuals the opportunity to participate in something called a designated Roth account. It's essentially a feature of the 401(k) plan where you contribute funds to a separate account.

Tax Treatment & Advantages

The main differences lie in the tax treatment of fund contributions and distributions. A Roth 401(k) lets you invest money with after-tax dollars. This income would therefore be  included in your gross income for the year. On the flip side, your earnings are able to grow tax free, and any future qualified distributions from the account are generally tax free. This differs from a traditional 401(k) in which employees contribute before-tax dollars and then deduct those contributions from their gross income with future withdrawals being taxed down the road.

A major advantage to a Roth 401(k) plan is that there are no income limitations. Therefore, even if you are phased out of making contributions to a Roth IRA due to higher income, you can still take advantage of the perks of a Roth account this way.

Contribution Limits & Flexibility

In 2023, an employee can contribute up to $22,500, and those who are at least 50-years-old can contribute up to $30,000. Contribution limits are aggregate, meaning this limit applies to the total contributed to a traditional 401(k) and the Roth 401(k) for the entire year.

Contributing isn’t an either/or proposition. You can contribute to both a traditional and a Roth 401(k) during the same year as well.

Employee Matching

Generally, employers will offer matching contributions just like they do on a traditional 401(k) account. However, any employer contributions must be allocated into the pre-tax account in your 401(k) plan. Only your own contributions will be allocated into the designated Roth account.

When Can I Withdraw from a Roth 401(k)?

Provided the withdrawal is considered a qualified distribution, the contributions and earnings are not taxed. To be a qualified distribution, the account must have been opened for at least 5 years, and the distribution must be made in one of three circumstances:

• On account of disability

• On or after death

• On or after age 59 1/2

For 2022 and 2023, regular required minimum distribution rules will still apply, if applicable. You’re required to take distributions by age 72 (or by age 73, if you reached 72 after 12/31/22), unless you’re still working and not a 5% owner of the company. If you withdraw funds prior to meeting this criteria, you pay a 10% penalty fee on the amount distributed. You also must include the earnings portion of the  non-qualified distribution in your gross income.

Beginning in 2024, however, required minimum distributions will no longer be required from designated Roth accounts.

What Is the Roth 401(k) 5-Year Rule?

This rule states the account must have been open for at least 5 years before you can take out a distribution that’s considered qualified. The time limit starts on the first day of the taxable year in which you make your first contribution. If you leave your original 401(k) plan and roll that money into another plan, the original five-year start date remains. You don’t lose any time.

When Is the Roth 401(k) Right?

While the Roth 401(k) is immensely beneficial, each person’s individual situation dictates what investment vehicles best serve them. At Capstone, we consider your age, retirement vision, planning goals, current and future income, and tax liabilities. This tells us when a Roth 401(k) or any investment vehicle maximizes your retirement planning portfolio.

Disclosures:

This article is not a substitute for personalized advice from Capstone and nothing contained in this presentation is intended to constitute legal, tax, accounting, securities, or investment advice, nor an opinion regarding the appropriateness of any investment, nor a solicitation of any type. This article is current only as of the date on which it was sent. The statements and opinions expressed are, however, subject to change without notice based on market and other conditions and may differ from opinions expressed by other businesses and activities of Capstone. Descriptions of Capstone’s process and strategies are based on general practice, and we may make exceptions in specific cases. A copy of our current written disclosure statement discussing our advisory services and fees is available for your review upon request.