Most everyone has heard of a 401(k) plan, and a sizable number of adults likely have at least a passing familiarity with the Roth IRA. What remains less well known among job candidates and employees is the Roth 401(k) plan. This retirement benefit with a twist might be worth offering to your staff, so long as you and they understand how it works.
HYBRID PLAN
As the name implies, Roth 401(k) plans that take some characteristics from employer-sponsored 401(k)s and others from Roth IRAs. Any employer with an existing 401(k), 403(b) or governmental 457(b) plan can offer designated Roth 401(k) accounts.
From there, eligible employees can elect to defer part of their salaries to Roth 401(k)s, subject to annual limits. The employer may choose to provide matching contributions. For 2020, a participating employee can contribute up to $19,500 ($26,000 if he or she is age 50 or older) to a Roth 401(k). The most you can contribute to a Roth IRA for 2020 is $6,000 ($7,000 for those age 50 or older).
Note: The ability to contribute to a Roth IRA is phased out for upper-income taxpayers, but there’s no such restriction for a Roth 401(k).
PROS AND CONS
Unlike the traditional 401(k)s, contributions to employees’ accounts are made with after-tax dollars, instead of pretax dollars. Therefore, employees forfeit a key 401(k) tax benefit. One the plus side, after an initial period of five years, “qualified distributions” are 100% exempt from federal income tax, just like qualified distributions from a Roth IRA. In contrast, regular 401(k) distributions are taxed at ordinary income rates, which are currently up to 37%.
Generally, qualified distributions are those made after a participant reaches 59 ½ or because of a death or disability. Therefore, you can take qualified Roth 401(k) distributions in retirement after 59 ½ and pay no tax, as opposed to the hefty tax bill that may be due from traditional 401(k) payouts. And unlike traditional 401(k)s, which currently force retirees to begin taking required minimum distributions after age 72, Roth 401(k)s have no mandated withdrawals.
NOT FOR EVERYONE
A Roth 401(k) is more beneficial than a traditional 401(k) for some participants, but not all. For example, it may be valuable for employees who expect to be in higher federal and state tax brackets in retirement than in their working years. Contact us if you have questions about adding a Roth 401(k) to your benefits lineup.