Rules for a Roth 401(k)

Submitted by Jim Blankenship on Monday, August 11, 2014 - 12:00pm
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If your employer sponsors a 401(k) plan for you to participate in, you may also have a Roth 401(k) option. Electing that option depends on your other retirement plans, tax outlook and many other factors.

The Roth 401(k) option, aka a designated Roth account (DRAC), became available in 2006 after passage of the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA). The Roth 401(k) aimed to provide features similar to those in a Roth individual retirement account to the employer-provided 401(k)-type plans.

Note: Unless specified otherwise, rules we discuss also apply to other qualified retirement plans such as 403(b)s for school and tax-exempt organization employees or the federal government’s 457(b) plans.

Similarities. Certain features of the Roth 401(k) resemble the traditional 401(k). For example, you can elect to defer a portion of your income into the account and your employer may match your contributions based on the elected deferrals.

The deferred funds go into a separate account for selected investment options. While in the plan (before distribution) the funds grow tax-free. When you reach retirement age (usually at least 59½), you can withdraw the funds without penalty.

You can roll over funds into another employer’s plan or a like-ruled IRA without tax or penalty. If your funds remain in a Roth 401(k) when you reach 70½ and the plan sponsor no longer employs you (or you are still with the same employer and a 5% or greater owner in the company), the Internal Revenue Service requires you to begin taking required minimum distribution withdrawals from the plan.

Differences. Some very important features about the Roth 401(k) differ from the traditional 401(k) but closely resemble features of a Roth IRA.

Unlike the traditional 401(k), funds deferred into the Roth 401(k) incur ordinary income tax. Growth in your account is tax-deferred – and, if you make withdrawals after age 59½, you pay no income tax on the distributions, the same treatment funds contributed to a Roth IRA receive.

Employer-provided matching funds are contributed to a traditional 401(k) account rather than to the Roth 401(k). Vesting rules apply just as with the traditional 401(k) and only to the matching funds.

For your Roth 401(k) distributions to qualify as fully tax-free, you need to establish your account at least five years before taking the distribution and you must be at least 59½.

Combination rules. Your contributions for any tax year to all your 401(k) plans, traditional or Roth, for all employers cannot exceed the annual deferral limit of $17,500 for 2014, plus a $5,500 catch-up if you’re over 50.

Rollovers from the plan to an outside plan – such as a Roth IRA or another employer’s Roth 401(k) plan – are generally not allowed until you cease employment with the plan sponsor.

Although you probably receive one statement that details both your traditional and Roth 401(k) plans, the plans remain in separate accounts. This simplifies future tax treatment of the funds.

Also, when you have deferred funds in a Roth 401(k) account, this action is irreversible; you cannot, without penalty, move the funds into your traditional account or take them in cash after you defer them into the Roth 401(k).

Your employer can allow in-service rollovers (or conversions) from the traditional 401(k) to the Roth 401(k), paying ordinary income tax on the converted funds in the tax year of the conversion. These conversions are an allowed, non-penalized distribution from your 401(k) plan.

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Jim Blankenship, CFP, EA, is an independent, fee-only financial planner at Blankenship Financial Planning in New Berlin, Ill. He is the author of An IRA Owner’s Manual and A Social Security Owner’s Manual. His blog is Getting Your Financial Ducks In A Row, where he writes regularly about taxes, retirement savings and Social Security.

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