Since Congress made Roth 401k plans a permanent fixture in the qualified retirement plan world, more companies are making this available to their employees. You have the ability to contribute money to a Roth 401k, in addition to a traditional 401k plan. Knowing how Roth 401k plans work helps you make the best decision as to which plan is right for you.
Roth 401k Function
When you make contributions to your Roth 401k plan through your employer, you do not receive an income tax benefit for the deferrals. This is because Roth 401k plans offer after-tax savings, not pretax savings like a traditional 401k plan. While the money is in your Roth 401k plan, it grows without being subject to income taxes. After the account has been open for five years and you are at least 59 1/2 years old, you can take qualified distributions, which means the money comes out tax free.
Roth individual 401k contribution limits vary each year with inflation. As of 2011, you can contribute up to $16,500 per year, or your total compensation, whichever is less. However, this limit is cumulative with traditional 401k contributions. So if you max out your traditional 401k plan, you cannot contribute more to your Roth 401k. Your employer may not contribute to your Roth 401k plan. Your employer can still match your contributions, but those matching contributions must go in a separate traditional 401k plan.
When you take a nonqualified distribution from your Roth 401k, you have to divide the distribution between nontaxable contributions and taxable earnings. The percentages are based on the makeup of your Roth 401k plan. For example, if your Roth 401k has 47 percent contributions, then 47 percent of your withdrawal is tax free and penalty free. In addition to income taxes on the earnings, you also have to pay a 10 percent tax penalty. This penalty only applies to the taxable portion.
In the year that you turn 70 1/2 years old, you must start taking minimum required distributions (RMDs) from the account, just like you would have to with a traditional 401k plan. The size of these required distributions depends on how much you have in your Roth 401k plan, and your age. You can avoid these RMDs by rolling your Roth 401k plan into a Roth IRA.
- Photos.com/Photos.com/Getty Images