How Is a Roth 401(k) Taxed?

How exactly is a Roth 401(k) taxed? The essence is that you don’t get a tax deduction when you contribute part of your pay to it, just as you get with a traditional 401(k). Instead, a Roth 401(k) allows employees to contribute after-tax dollars. The payoff is that this money and its earnings over the years are not subject to income tax when you withdraw them after retiring.

These plans have only been available since 2006, but they are gaining in popularity as a way to establish a retirement income that is free from tax liability. 

Not all company-sponsored retirement schemes offer a Roth 401(k). But in just the last five years, the percent of plans offering Roth in 401(k)’s have increased by 29%. This option has been increasingly popular with younger participants and contributions are also on the rise. Millennial Roth IRA accounts increased 58.5% in Q3 2021 YTD compared to Q3 2020 YTD, with overall dollar contributions increasing 58.1%.

Key Takeaways

• The main advantage of a Roth 401(k) is that withdrawals are tax-free in retirement.
• Like other retirement accounts, distributions taken before age 59½ are subject to an early withdrawal penalty.
• Since there’s no income limit, Roth 401(k) tax advantages can be particularly appealing to high earners.

Let’s take a look at the tax nuances of Roth 401(k)s and how they differ from a traditional 401(k) and a Roth IRA.

A Closer Look at Taxes and Retirement

Before you make the Roth 401(k) choice, consider the following tax consequences.

The Paycheck Hit

In any qualified retirement account, including the traditional and Roth 401(k), no additional tax is due from year to year while the funds stay in the account.

The immediate downside for participants in a Roth 401(k) is that the taxes on the income paid into the account are due that year. One of the biggest benefits of the traditional 401(k) is that it postpones the income tax on that money until years down the road, when the account owner withdraws it after retiring. Moreover, the money paid into the traditional account is deducted from the person’s gross income. Effectively, that means lower immediate income taxes paid, offsetting part of the contribution.

Contributions to a Roth 401(k) must be made by the employer’s tax filing deadline.

The Tax Hit After Retiring

The point of either type of account is to provide the saver with a source of income after retiring. And there are big differences in the way each type of account is taxed:

• If it is a Roth account, all the taxes owed have already been paid. No further income taxes are due on either the contributions or the profits they earned over the years.
• If it is a traditional account, taxes are owed on both the contributions and the earnings.

Employer Contributions

An employer may offer a matching contribution for either a Roth or a traditional 401(k). Not all employers do, but some will match up to 3% or more of the employee’s contribution.

In either case, the employer match is pre-tax money. The amount contributed will be subject to income tax when it is withdrawn after retiring.

You might consider this a minor issue, since the rest of your Roth account is tax-free. It might even be an advantage, offsetting the amount you owe for taxes on all of your income.

No Income Restrictions (Unlike a Roth IRA)

A major tax advantage of a Roth 401(k) is the opportunity for higher-earning individuals to contribute more dollars into a retirement account that will be tax-free at retirement. Higher-income individuals do not qualify to open a Roth IRA, but they can contribute to a Roth 401(k).

For the tax year 2022, the annual income limit for contributions to a Roth IRA is a modified adjusted gross income (MAGI) of $144,000 for singles with a phase-out starting at $129,000. For those married filing jointly, MAGI must be less than $214,000, with phase-outs starting at $204,000.

For 2023, the MAGI limit rises to $153,00, with a phase-out starting at $136,000, for single filers. For those married filing jointly, the MAGI must be less than $228,000, with a phase-out starting at $218,000.

The Roth 401(k) has no such income restrictions. Contributions are, however, limited to $20,500 per year for the tax year 2022 (rising to $22,500 for 2023), with another $6,500 for participants over the age of 50 (rising to $7,500 for 2023). These are the same amounts permitted for contributions to a regular 401(k).

RMDs: You Do Have to Take Them

There’s a difference between how annual required minimum distributions (RMDs) are handled for a Roth 401(k) compared to a Roth IRA.

Roth IRAs do not mandate RMDs during the lifetime of the account holder. Roth 401(k)s do. The good news: The money is not taxable, unlike the money you take from a traditional 401(k). Even better, because Roth 401(k) distributions are not taxable, they have no impact on the taxability of your Social Security benefits.

The bad news: Once you take a distribution from your Roth 401(k), that money cannot continue to grow tax-free.

But There’s a Way Out

There is a good way around this. If you roll over your Roth 401(k) into a Roth IRA at retirement, you will no longer have the RMD requirement. That is one way for high-income individuals to acquire a Roth IRA they otherwise would be too affluent to qualify to open.

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