Employers can offer 401(k) plan participants the opportunity to make Roth 401(k) contributions. If you’re lucky enough to work for an employer who offers this option, Roth contributions could play an important role in maximizing your retirement income.

Are distributions really tax free?

Because your Roth 401(k) contributions are made on an after-tax basis, they’re always free from federal income tax when distributed from the plan. Investment earnings on your Roth contributions are tax free if you meet the requirements for a “qualified distribution.”

In general, a distribution from your Roth 401(k) account is qualified if it satisfies both of the following requirements:

  • It’s made after the end of a five-year waiting period
  • The payment is made after you turn 59½, become disabled, or die

The five-year waiting period for qualified distributions starts on January 1 of the year you make your first Roth contribution to the 401(k) plan. For example, if you make your first Roth contribution to your employer’s 401(k) plan in December 2018, your five-year waiting period begins January 1, 2018, and ends on December 31, 2022. If you participate in more than one Roth 401(k) plan, your five-year waiting period is generally determined separately for each employer’s plan. But if you change employers and directly roll over your Roth 401(k) account from your prior employer’s plan to your new employer’s Roth 401(k) plan (assuming the new plan accepts rollovers), the five-year waiting period for your new plan starts instead with the year you made your first contribution to the earlier plan.

If your distribution isn’t qualified (for example, if you receive a payout before the five-year waiting period has elapsed), the portion of your distribution that represents investment earnings on your Roth contributions will be taxable, and will be subject to a 10% early distribution penalty unless you’re 59½ (55 in some cases) or another exception applies. You can generally avoid taxation by rolling all or part of your distribution over into a Roth IRA or into another employer’s Roth 401(k) or 403(b) plan, if that plan accepts Roth rollovers. (State income tax treatment of Roth 401(k) contributions may differ from the federal rules.)

If you contribute to both a Roth 401(k) and a Roth IRA, a separate five-year waiting period applies to each. Your Roth IRA five-year waiting period begins with the first year that you make a regular or rollover contribution to any Roth IRA.

What about employer contributions?

Employers don’t have to contribute to 401(k) plans, but many will match all or part of your contributions. Your employer can match your Roth contributions, your pre-tax contributions, or both. But your employer’s contributions are always made on a pre-tax basis, even if they match your Roth contributions. That is, your employer’s contributions, and investment earnings on those contributions, are not taxed until you receive a distribution from the plan. Your 401(k) plan may require up to six years of service before you fully own employer matching contributions. (Note: If your plan is a SIMPLE 401(k) plan, a safe-harbor 401(k) plan, or includes a qualified automatic contribution arrangement (QACA) your employer is required to make a contribution on your behalf, and special vesting rules apply.)