![Understanding Roth 401(k) Plans [2024]](https://scarletoakfs.com/wp-content/uploads/2023/12/Roth-401k-header-scaled.jpg)
Roth plans are a hybrid offered by employers that combine traditional 401(k) aspects with Roth IRAs. They are a relatively newer type of plan, created in 2001 to offset some of the economic effects of the recession of the time. Employers since 2006 have been able to amend their Traditional 401(k) plans to let participants make part or all of their contributions to Roth.[1]
Key aspects of Roth 401(k) plans
- Roth contributions are post-tax contributions, taxed when you earn the income, not when the retirement distribution is made. So, say you earn $2000 per paycheck and contribute $200 as a Roth contribution. You will still pay taxes on the $2000. Whereas if you had made a traditional 401(k) contribution of $200, you’d pay taxes on an adjusted paycheck of $1800.[2],[3]
- With all investment accounts, you expose some or all your invested money to loss for the chance to earn a higher profit. Investment gains hinge on an ongoing and long-term investment strategy that uses your risk tolerance and diversification to mitigate some risks. Even with these in place, you are exposing your money to loss. [4]
- Employers must also offer the Traditional 401(k) plan, so some employers do not offer Roth 401(k) plans because of the extra burden of running two funds. Separate recordkeeping for each participant’s Roth and non-Roth accounts.1,[5]
- No income limits to participate.[6]
- Employers must allow all employees to participate if they are 21 and above, have one year of service, and have 1000 hours of service per year. There are some restrictions beyond this for people who are not US citizens and some types of union members.
- Employers usually match at the same rate as traditional 401(k) plans; the average match for most companies in 2023 was 5%.[8]
- Vesting is when you must stay with an employer to keep any money they match. The vesting period varies with employers but usually is in the range of 3 to 6 years. There are also variations in vesting schedules. Cliff vesting is where you go 100% vested at a set period. Graded vesting is where you earn a percentage of 100% each year. An example would be you are 33% vested in year one, 66% in year two, and 100% in year three.[9]
- A 401(k)-plan sponsor is the plan fiduciary, legally responsible for selecting the plan’s investment options and monitoring their suitability. Generally, your employer is your 401(k)-plan sponsor.[10]
- 401(k)s are required to perform nondiscrimination tests (NDTs) annually to ensure that 401(k) retirement plans benefit all employees, not just high earners or company owners.[11]
- Fees vary from plan to plan, but the three categories are investment fees, plan administration fees, and individual service fees. It is crucial to understand how much you are paying in fees. [12]
- If you leave an employer, you can take your money with you. A Roth 401(k) can be rolled over to a new or existing Roth IRA or 401(k).[13]
- The earliest you can take penalty-free withdrawals is 59 ½; the penalty is an extra 10% on top of the taxes collected. However, there are some exemptions to the early withdrawal penalty- if you are permanently and totally disabled, if you lose your job at 55 or older, if you have medical expenses that exceed 10% of your modified adjusted gross income, with some divorce settlement types and if you die. This type of account must be opened five years before any distributions are made.[14]
- You can take a low-interest loan on Roth 401(k) accounts, up to $50,000 or 50% of your account balance. Still, you will have to pay it back sometimes within 90 days but definitely within five years (this period may be extended if the money is used to buy a primary home) or at leaving that job, or it becomes taxable income. The payments will most likely be held back from your paycheck. Some plans don’t let you contribute to your account until the loan is paid back. Interest charges go directly back into your retirement account.[17]
If you want to explore investment accounts that would work for your personal or retirement goals, Scarlet Oak Financial Services can be reached at 800.871.1219, or you can contact us here. To sign up for our weekly newsletter with the latest economic news, click here.
Sources:
[1] https://www.groom.com/wp-content/uploads/2017/09/1161_Roth_401k_Plans.pdf
[2] https://www.investopedia.com/terms/r/roth401k.asp
[3] https://www.nerdwallet.com/article/investing/roth-401k
[4] https://www.investor.gov/sites/investorgov/files/2019-02/Saving-and-Investing.pdf
[5] https://www.investopedia.com/ask/answers/102714/are-roth-401k-plans-matched-employers.asp
[6] https://www.irs.gov/retirement-plans/roth-comparison-chart
[7] https://www.irs.gov/newsroom/401k-limit-increases-to-23000-for-2024-ira-limit-rises-to-7000
[8] https://www.investopedia.com/articles/personal-finance/120315/what-good-401k-match.asp
[9] https://www.gobankingrates.com/retirement/401k/is-money-401k-really-vesting-works/
[10] https://www.irs.gov/newsroom/irs-announces-changes-to-retirement-plans-for-2022
[11] https://www.forusall.com/401k-blog/401k-nondiscrimination-testing/
[12] https://smartasset.com/retirement/what-are-401k-fees
[13] https://www.bokfinancial.com/resources/articles/commercial-institutional/the-roth-401k
[14] https://www.investopedia.com/ask/answers/101314/what-are-roth-401k-withdrawal-rules.asp#roth-401ks-the-basics
[15] https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-required-minimum-distributions-rmd
[16] https://www.tiaa.org/public/support/faqs/required-minimum-distributions
[17] https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-loans
This material has been prepared for informational purposes. To the extent that this material concerns tax matters, it is not intended or written to be used, and cannot be used, by a taxpayer for the purpose of avoiding penalties that may be imposed by law. Each taxpayer should seek independent advice from a tax professional based on individual circumstances.
