The Roth 401(k)

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Some employers 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 helping enhance your retirement income.

What is a Roth 401(k)?

A Roth 401(k) is simply a traditional 401(k) plan that accepts Roth 401(k) contributions. Roth 401(k) contributions are made on an after-tax basis, just like Roth IRA contributions. This means there’s no up-front tax benefit, but if certain conditions are met, your Roth 401(k) contributions and all accumulated investment earnings on those contributions are free from federal income tax when distributed from the plan. (403(b) and 457(b) plans can also allow Roth contributions.)

Who can contribute?

Unlike Roth IRAs, where individuals who earn more than a certain dollar amount aren’t allowed to contribute, you can make Roth contributions, regardless of your salary level, as soon as you’re eligible to participate in the plan. And while a 401(k) plan can require employees to wait up to one year before they become eligible to contribute, many plans allow you to contribute beginning with your first paycheck.

How much can I contribute?

There’s an overall cap on your combined pretax and Roth 401(k) contributions. You can contribute up to $18,000 of your pay ($24,000 if you’re age 50 or older) to a 401(k) plan in 2016. You can split your contribution any way you wish. For example, you can make $10,000 of Roth contributions and $8,000 of pretax 401(k) contributions. It’s up to you.

But keep in mind that if you also contribute to another employer’s 401(k), 403(b), SIMPLE, or SAR-SEP plan, your total contributions to all of these plans–both pretax and Roth–can’t exceed $18,000 ($24,000 if you’re age 50 or older). It’s up to you to make sure you don’t exceed these limits if you contribute to plans of more than one employer.

Can I also contribute to a Roth IRA?

Yes. Your participation in a Roth 401(k) plan has no impact on your ability to contribute to a Roth IRA. You can contribute to both if you wish (assuming you meet the Roth IRA income limits). You can contribute up to $5,500 to a Roth IRA in 2016, $6,500 if you’re age 50 or older (or, if less, 100% of your taxable compensation).1

Should I make pretax or Roth 401(k) contributions?

When you make pretax 401(k) contributions, you don’t pay current income taxes on those dollars 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, pretax 401(k) contributions may be more appropriate. Your investment horizon and projected investment results are also important factors. Before you take any specific action be sure to consult with your own tax or legal counsel.

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. But the investment earnings on your Roth contributions are tax free only if you meet the requirements for a “qualified distribution.”

In general, a distribution is qualified only if it satisfies both of the following:

  • 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 with the year you make your first Roth contribution to your employer’s 401(k) plan. For example, if you make your first Roth contribution to the plan in December 2016, then the first year of your five-year waiting period is 2016, and your waiting period ends on December 31, 2020.

But if you change employers and roll over your Roth 401(k) account from your prior employer’s plan to your new employer’s plan (assuming the new plan accepts Roth rollovers), the five-year waiting period 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 or because you terminate employment), 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 are 59½ or another exception applies.

You can generally avoid taxation by rolling your distribution over into a Roth IRA or into another employer’s Roth 401(k), 403(b), or 457(b) plan, if that plan accepts Roth rollovers. (State income tax treatment of Roth 401(k) contributions may differ from the federal rules.)2

What about employer contributions?

While employers don’t have to contribute to 401(k) plans, many will match all or part of your contributions. Your employer can match your Roth contributions, your pretax contributions, or both. But your employer contributions are always made on a pretax 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 plan distribution.

What else do I need to know?

Like pretax 401(k) contributions, your Roth 401(k) contributions and investment earnings can be paid from the plan only after you terminate employment, incur a financial hardship, attain age 59½, become disabled, or die.

Also, 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 this isn’t as significant as it might seem, since you can generally roll over your Roth 401(k) dollars (other than RMDs themselves) into a Roth IRA if you don’t need or want the lifetime distributions.

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 feature to your plan.

Roth 401(k) Roth IRA
Maximum contribution (2016) Lesser of $18,000 or 100% of compensation Lesser of $5,500 or 100% of compensation
Age 50 catch-up (2016) $6,000 $1,000
Who can contribute? Any eligible employee Only if under income limit
Age 70½ required distributions? Yes No
Potential matching contributions? Yes No
Potential loans? Yes No
Tax-free qualified distributions? Yes, 5-year waiting period plus either 59½, disability, or death Same, plus first time homebuyer expenses (up to $10,000 lifetime)
Nonqualified distributions Pro-rata distribution of tax-free contributions and taxable earnings Tax-free contributions distributed first, then taxable earnings
Investment choices Limited to plan options Virtually unlimited
Federal bankruptcy protection Unlimited $1,283,025 (All IRAs aggregated)3

1If you have both a traditional IRA and a Roth IRA, your combined contributions to both cannot exceed $5,500 ($6,500 if age 50 or older) in 2016.

2You can avoid tax on the non-Roth portion of your distribution (any pretax contributions, employer contributions, and investment earnings on these contributions) by rolling that portion over into a traditional IRA.

3SEP/SIMPLE IRAs and amounts rolled over from qualified employer retirement plans and 403(b) plans are not included in or subject to this limit, and are fully protected if you declare bankruptcy. Inherited IRAs are not entitled to federal bankruptcy protection but may be protected under the laws of some states.

©2016 Broadridge Investor Solutions, Inc.

401(k) Plans

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401(k) Plans

Qualified cash or deferred arrangements (CODAs) permitted under Section 401(k) of the Internal Revenue Code, commonly referred to as “401(k) plans,” have become one of the most popular types of employer-sponsored retirement plans.

How does a 401(k) plan work?

With a 401(k) plan, you elect either to receive cash payments (wages) from your employer immediately, or defer receipt of a portion of that income to the plan. The amount you defer (called an “elective deferral” or “pretax contribution”) isn’t currently included in your income; it’s made with pretax dollars. Consequently, your federal taxable income (and federal income tax) that year is reduced. And the deferred portion (along with any investment earnings) isn’t taxed to you until you receive payments from the plan.

Example:  Melissa earns $30,000 annually. She contributes $4,500 of her pay to her employer’s 401(k) plan on a pretax basis. As a result, Melissa’s taxable income is $25,500. She isn’t taxed on the deferred money ($4,500), or any investment earnings, until she receives a distribution from the plan.

You may also be able to make Roth contributions to your 401(k) plan. Roth 401(k) contributions are made on an after-tax basis, just like Roth IRA contributions. Unlike pretax contributions to a 401(k) plan, there’s no up-front tax benefit, but qualified distributions from a Roth 401(k) account are entirely free from federal income tax.

When can I contribute?

You can contribute to your employer’s 401(k) plan as soon as you’re eligible to participate under the terms of the plan. In general, a 401(k) plan can make you wait up to a year before you’re eligible to contribute. But many plans don’t have a waiting period at all, allowing you to contribute beginning with your first paycheck.

Some 401(k) plans provide for automatic enrollment once you’ve satisfied the plan’s eligibility requirements. For example, the plan might provide that you’ll be automatically enrolled at a 3% pretax contribution rate (or some other percentage) unless you elect a different deferral percentage, or choose not to participate in the plan. This is sometimes called a “negative enrollment” because you haven’t affirmatively elected to participate–instead you must affirmatively act to change or stop contributions. If you’ve been automatically enrolled in your 401(k) plan, make sure to check that your assigned contribution rate and investments are appropriate for your circumstances.

How much can I contribute?

There’s an overall cap on your combined pretax and Roth 401(k) contributions. You can contribute up to $18,000 of your pay ($24,000 if you’re age 50 or older) to a 401(k) plan in 2016. If your plan allows Roth 401(k) contributions, you can split your contribution between pretax and Roth contributions any way you wish. For example, you can make $10,000 of Roth contributions and $8,000 of pretax 401(k) contributions. It’s up to you.

But keep in mind that if you also contribute to another employer’s 401(k), 403(b), SIMPLE, or SAR-SEP plan, your total contributions to all of these plans–both pretax and Roth–can’t exceed $18,000 ($24,000 if you’re age 50 or older). It’s up to you to make sure you don’t exceed these limits if you contribute to plans of more than one employer.

Can I also contribute to an IRA?

Yes. Your participation in a 401(k) plan has no impact on your ability to contribute to an IRA (Roth or traditional). You can contribute up to $5,500 to an IRA in 2016, $6,500 if you’re age 50 or older (or, if less, 100% of your taxable compensation). But, depending on your salary level, your ability to make deductible contributions to a traditional IRA may be limited if you participate in a 401(k) plan.

What are the tax consequences?

When you make pretax 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. In general, a distribution from your Roth 401(k) account is qualified only 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 with 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 2016, your five-year waiting period begins January 1, 2016, and ends on December 31, 2020. Each nonqualified distribution is deemed to consist of a pro-rata portion of your tax-free contributions and taxable earnings.

What about employer contributions?

Many employers will match all or part of your contributions. Your employer can match your Roth contributions, your pretax contributions, or both. But your employer’s contributions are always made on a pretax basis, even if they match your Roth contributions. That is, your employer’s contributions, and investment earnings on those contributions, are always taxable to you when you receive a distribution from the plan.

Should I make pretax or Roth contributions?

Assuming your 401(k) plan allows you to make Roth 401(k) contributions, which option should you choose? It depends on 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, pretax 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 appropriate for you.

Whichever you decide–Roth or pretax–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 reach your retirement goals that much sooner.

What happens when I terminate employment?

Generally, you forfeit all contributions that haven’t vested. “Vesting” means that you own the contributions. Your contributions, pretax and Roth, are always 100% vested. But your 401(k) plan may generally 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 take a distribution (all or part of which may be taxable to you), leave your money in your 401(k) plan (if your vested balance exceeds $5,000) until the plan’s normal retirement age (typically age 65), or you can roll your dollars over tax free to an IRA or to another employer’s retirement plan that accepts rollovers.*

What else do I need to know?

  • Saving for retirement is easier when your contributions automatically come out of each paycheck
  • You may be eligible to borrow up to one-half of your vested 401(k) account (to a maximum of $50,000) if you need the money
  • You may be able to make a hardship withdrawal if you have an immediate and heavy financial need. But this should be a last resort–hardship distributions are taxable events (except for Roth qualified distributions), and you may be suspended from plan participation for six months or more
  • If you receive a distribution from your 401(k) plan before you turn 59½, (55 in certain cases), the taxable portion may be subject to a 10% early distribution penalty unless an exception applies
  • Depending on your income, you may be eligible for an income tax credit of up to $1,000 for amounts contributed to the 401(k) plan
  • Your assets are generally fully protected from creditors in the event of your, or your employer’s, bankruptcy

©2016 Broadridge Investor Solutions, Inc.
IMPORTANT DISCLOSURES

CMC Interactive, LLC does not provide investment, tax, or legal advice. The information presented here is not specific to any individual’s personal circumstances.

To the extent that this material concerns tax matters, it is not intended or written to be used, and cannot be used, by a taxpayer for the purpose of avoiding penalties that may be imposed by law. Each taxpayer should seek independent advice from a tax professional based on his or her individual circumstances.

These materials are provided for general information and educational purposes based upon publicly available information from sources believed to be reliable—we cannot assure the accuracy or completeness of these materials. The information in these materials may change at any time and without notice.

Projecting a Happy Retirement

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A 2015 study found that 41% of households headed by someone aged 55 to 64 had no retirement savings, and only about a third of them had a traditional pension. Among households in this age group with savings, the median amount was just $104,000.1

Your own savings may be more substantial, but in general Americans struggle to meet their savings goals. Even a healthy savings account may not provide as much income as you would like over a long retirement.

Despite the challenges, about 56% of current retirees say they are very satisfied with retirement, and 34% say they are moderately satisfied. Only 9% are dissatisfied.2

Develop a realistic picture

How can you transition into a happy retirement even if your savings fall short of your goals? The answer may lie in developing a realistic picture of what your retirement will look like, based on your expected resources and expenses. As a starting point, create a simple retirement planning worksheet. You might add details once you get the basics down on paper.

Estimate income and expenses

You can estimate your monthly Social Security benefit at ssa.gov. The longer you wait to claim your benefits, from age 62 up to age 70, the higher your monthly benefit will be. If you expect a pension, estimate that monthly amount as well. Add other sources of income, such as a part-time job, if that is in your plans. Be realistic. Part-time work often pays low wages.

It’s more difficult to estimate the amount of income you can expect from your savings; this may depend on unpredictable market returns and the length of time you need your savings to last. One simple rule of thumb is to withdraw 4% of your savings each year. At that rate, the $104,000 median savings described earlier would generate $4,160 per year or $347 per month (assuming no market gains or losses). Keep in mind that some experts believe a 4% withdrawal rate may be too high to maintain funds over a long retirement. You might use 3% or 3.5% in your calculations.

Now estimate your monthly expenses. If you’ve paid off your mortgage and other debt, you may be in a stronger position. Don’t forget to factor in a reserve for medical expenses. One study suggests that a 65-year-old couple who retired in 2015 would need $259,000 over their lifetimes to cover Medicare premiums and out-of-pocket health-care expenses, assuming they had only median drug expenses.3

Take strategic steps

Your projected income and expenses should provide a rough picture of your financial situation in retirement. If retirement is approaching soon, try living for six months or more on your anticipated income to determine whether it is realistic. If it’s not, or your anticipated expenses exceed your income even without a trial run, you may have to reduce expenses or work longer, or both.

Even if the numbers look good, it would be wise to keep building your savings. You might take advantage of catch-up contributions to IRAs and 401(k) plans, which are available to those who reach age 50 or older by the end of the calendar year. In 2016, the IRA catch-up amount is $1,000, for a total contribution limit of $6,500. The 401(k) catch-up amount is $6,000, for a total employee contribution limit of $24,000.

Preparing for retirement is not easy, but if you enter your new life phase with eyes wide open, you’re more likely to enjoy a long and happy retirement.

1U.S. Government Accountability Office, “Retirement Security,” May 2015

2 The Wall Street Journal, “Why Retirees Are Happier Than You May Think,” December 1, 2015

3Employee Benefit Research Institute, Notes, October 2015

 
IMPORTANT DISCLOSURES

©Broadridge Investor Solutions, Inc.

CMC Interactive, LLC does not provide investment, tax, or legal advice. The information presented here is not specific to any individual’s personal circumstances.

To the extent that this material concerns tax matters, it is not intended or written to be used, and cannot be used, by a taxpayer for the purpose of avoiding penalties that may be imposed by law. Each taxpayer should seek independent advice from a tax professional based on his or her individual circumstances.

These materials are provided for general information and educational purposes based upon publicly available information from sources believed to be reliable—we cannot assure the accuracy or completeness of these materials. The information in these materials may change at any time and without notice.