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.
Should I make pre-tax or Roth 401(k) contributions?
When you make pre-tax 401(k) contributions, you don’t pay current income taxes on those dollars (which means more take-home pay compared to an after-tax Roth contribution of the same amount). But your contributions and investment earnings are fully taxable when you receive a distribution from the plan. In contrast, Roth 401(k) contributions are subject to income taxes up front, but qualified distributions of your contributions and earnings are entirely free from federal income tax.
Which is the better option depends upon your personal situation. If you think you’ll be in a similar or higher tax bracket when you retire, Roth 401(k) contributions may be more appealing, since you’ll effectively lock in today’s lower tax rates. However, if you think you’ll be in a lower tax bracket when you retire, pre-tax 401(k) contributions may be more appropriate. Your investment horizon and projected investment results are also important factors. A financial professional can help you determine which course is best for you.
Whichever you choose — Roth or pre-tax — make sure you contribute as much as necessary to get the maximum matching contribution from your employer. This is essentially free money that can help you pursue your retirement goals.
What happens when I terminate employment?
When you terminate employment you generally forfeit all contributions (and earnings on them) that haven’t vested. “Vesting” means that you own the contributions and any associated earnings. Your contributions, Roth and pre-tax, are always 100% vested. But your 401(k) plan may require up to six years of service before you fully vest in employer matching contributions (although some plans have a much faster vesting schedule).
When you terminate employment you can generally leave your money in your 401(k) plan, although some plans require that you withdraw your funds when you reach the plan’s normal retirement age (typically age 65). (And you generally must begin taking distributions after you reach age 70½.) Your plan may also “cash you out” if your vested balance is $5,000 or less, but if your payment is more than $1,000, the plan must generally roll your funds into an IRA established on your behalf, unless you elect to receive your payment in cash. (This $1,000 limit is determined separately for your Roth 401(k) account and the rest of your funds in the 401(k) plan.)
You can also roll all or part of your Roth 401(k) dollars over to a Roth IRA, and your non-Roth dollars to a traditional IRA. You may also be able to roll your funds into another employer’s plans that accepts rollovers.
When considering a rollover, to either an IRA or to another employer’s retirement plan, you should consider carefully the investment options, fees and expenses, services, ability to make penalty-free withdrawals, degree of creditor protection, and distribution requirements associated with each option.
What else do I need to know?
- Like pre-tax 401(k) contributions, your Roth 401(k) contributions and investment earnings can generally be paid from the plan only after you terminate employment, attain age 59½, become disabled, or die.
- You may be eligible to borrow up to one half of your vested 401(k) account, including your Roth contributions, (to a maximum of $50,000) if you need the money.
- You may be able to make a hardship withdrawal if you (or your spouse, dependents, or plan beneficiary) have an immediate and heavy financial need. But this should be a last resort — a 10% penalty may apply to the taxable amount if you’re not yet age 59½, and you may be suspended from plan participation for six months or more if the withdrawal takes place in 2018.
- Unlike Roth IRAs, you must begin taking distributions from a Roth 401(k) plan after you reach age 70½ (or in some cases, after you retire), but you can generally roll over your Roth 401(k) dollars into a Roth IRA if you don’t need or want the lifetime distributions.
- Depending on your income, you may be eligible for an income tax credit of up to $1,000 for amounts you contribute to the 401(k) plan.
- Your assets are generally fully protected from creditors.
Employers aren’t required to make Roth contributions available in their 401(k) plans. So be sure to ask your employer if they are considering adding this exciting new feature to your 401(k) plan.