How is a Roth 401(k) taxed?

A Roth 401(k) is a type of plan that offers employees the ability to contribute after-tax dollars to a qualified retirement plan. These plans have only been available since January 2006, but they are gaining in popularity as more workers attempt to establish retirement income free from tax liability. 

Roth 401(k)s are not available in all company-sponsored retirement schemes. But when they are available and savers are aware of them, about 60% of employees opt for one over a traditional 401(k). Millennials are especially likely to contribute to a Roth 401(k).

Though employee contributions are after-tax dollars, with the opportunity for earnings to grow tax-free, no employer-match contributions can be allocated to the Roth portion of the account. Earnings grow tax-free within the Roth 401(k), and no taxes are incurred upon distribution in retirement.

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 have a Roth IRA, but they can contribute to a Roth 401(k). For tax year 2019, the annual income limit for contributions to a Roth IRA is $137,000 for singles with a phase-out starting at $122,000. For those married filing jointly, the MAGI is less than $203,000, with phase-out starting at $193,000. Those figures are up a bit from tax year 2018, when the phase-out for singles started at $120,000 and maxed out at $135,000. For those married filing jointly, the 2018 MAGI must be less than $199,000, with reductions beginning at $189,000.

The Roth 401(k) has no such income restrictions. Contributions are, however, limited to $19,000 per year for tax year 2019 (up from $18,500 in 2018) with another $6,000 for participants over the age of 50 (up from $5,500 in 2018). These are the same amounts permitted for contributions to a regular 401(k).

Contributions to a Roth 401(k) must be made before the end of the calendar year (Dec. 31), though any contributions made by an employer have until the employer's tax filing deadline.

Like other qualified retirement accounts, no tax is due for each year the funds are in the account. Also, since no deduction is given for contributions and no taxes are due for distributions in retirement, the only tax ramification for participating in a Roth 401(k) is losing the advantage of having the amount of your contribution  removed from your taxable income in the year that it is made. Lowering your taxable income is a key advantage of contributing to a regular 401(k). That aspect can be discussed with your tax advisor.

Distributions made prior to age 59½ are, like other retirement accounts, subject to an early withdrawal penalty. And 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, although 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.

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