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Advantages and Disadvantages of a Roth 401(k)

October 8, 2021

The biggest advantage of a Roth 401(k) is that appreciation of the contributions is never taxed. However, this comes because of the main disadvantage of Roth 401(k)s - contributions are elective contributions under a qualified 401(k) plan that unlike pre-tax 401(k) elective contributions, are currently includible in gross income. Therefore, contributions are from after-tax dollars.

Another advantage is that contributions can be made to a designated Roth 401(k) account even if income is too high to be eligible to contribute to a Roth IRA. Similar to a Roth IRA, an individual can begin distributions tax-free after age 59½ provided the individual has been in the plan for at least five tax years. One disadvantage of the Roth 401(k), as opposed to the Roth IRA, is that individuals are required to take distributions beginning when they turn age 70½. However, this rule can be circumvented by rolling over the Roth 401(k) account to a Roth IRA before turning 70½. The Roth IRA has no minimum distribution rules. Therefore, the funds in the account can continue to grow tax-free.

As mentioned above, for a distribution to be a qualified distribution and therefore not includible in income, a five-year requirement must be met for both Roth IRAs and Roth 401(k)s. In contrast to how the five-year period is calculated for Roth IRAs, the five-tax-year rule for Roth 401(k)s is the period of five consecutive tax years that begins with the first day of the first tax year in which the employee makes a Roth 401(k) contribution to any designated Roth account established for the employee under the same plan and ends when five consecutive tax years have been completed. For a Roth IRA, the five-tax-year period begins with the first tax year for which a contribution is made to any Roth IRA.

When it comes to early withdrawal, in the case of a Roth IRA, contribution comes first. therefore as long as the amount you withdraw from your Roth IRA stays within your contribution, you don’t have to worry about your tax or penalty. But if you pull out more than you have contributed, which means you tap earnings of your Roth IRA, a 10% penalty and income tax are imposed for the earnings’ portion. On the other hand, distributions from a Roth 401(k) are prorated between after-tax contributions and taxable earnings. Therefore, if the account has appreciated, any distribution that is not a qualified distribution will have a taxable income component.

Considering the above characteristics, the Roth 401 (k) is most likely beneficial for the taxpayer who expects his or her tax rate to be higher at the time of distribution than current tax rate, and who also cannot contribute to the Roth IRA due to income limitation. His or her employer needs to offer Roth 401 (k) plan. If the employer matches employees’ contribution, this choice is furthermore preferable.

There is a disadvantage for an employer setting up the Roth 401(k) because the Roth 401(k) accounts must be maintained separately from the pre-tax 401(k) accounts and employer contributions may only be made to the pre-tax 401(k) accounts. This makes having a Roth 401(k) plan more expensive for the employer because of the additional paperwork required.


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