Given the variety of retirement accounts that a small business can offer its employees, it's understandable if you are confused about which one is the right plan. It probably doesn't help that, if you've ever looked at 401(k) accounts, you've seen some labeled as "Roth" and others labeled as "traditional." What exactly distinguishes a Roth 401(k) from a traditional 401(k)?
The answer is that although Roth 401(k)s aren't that different from traditional 401(k)s, the two plans' differences are substantial enough that business owners like yourself should take note. We've written an in-depth explanation of Roth 401(k)s and compared them to traditional 401(k)s (and other retirement plans) below to help you navigate the often muddled mess of retirement lingo.
What is a Roth 401(k)?
A Roth 401(k) is an employer-sponsored retirement plan into which employees can deposit a portion of their post-tax income. Withdrawals from Roth 401(k) plans during retirement are not taxed.
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Although the Roth tax structure is the inverse of the traditional 401(k) structure, Roth 401(k)s include many of the same features as traditional 401(k)s. The main difference is that they add the tax structure of Roth individual retirement accounts (IRAs).
How does a Roth 401(k) work?
Roth 401(k) plans include the following provisions:
Designated Roth contributions
In some cases, you don't have to open a Roth 401(k) to make Roth contributions. You can add a feature called designated Roth accounts to an existing 401(k) plan so your employees can pay taxes on some contributions now instead of later. All designated Roth contributions are subject to the same rules as contributions to a standard Roth 401(k) plan.
Qualification
There is no income limit above which employees cannot make Roth contributions to a 401(k). Notably, there is an income limit on participation in a Roth IRA. For 2021, a married couple with a modified annual gross income (AGI) of at least $208,000 cannot participate in a Roth IRA. The same goes for a single person with a modified AGI of $140,000. However, both these groups can participate in Roth 401(k)s.
Contribution limits
In 2021, aggregate annual employee contributions to 401(k) accounts cannot surpass $19,500. Additionally, employees 50 and older can make aggregate annual catch-up contributions of up to $6,500.
The word "aggregate" is especially important when it comes to employee contributions. Aggregate contributions comprise money placed into both traditional and Roth plans. For example, if an employee deposits $19,500 into a traditional 401(k) account, they cannot contribute any money to a Roth 401(k) account. The limit applies across both accounts instead of per account.
Employer matching
As is common with 401(k) plans, Roth accounts allow for employer-matching contributions. However, unlike SEP IRAs and SIMPLE IRAs, Roth 401(k)s do not require employer-matching contributions.
With Roth 401(k)s, employer contributions work differently than employee ones. Whereas employee deposits are taxed, employer contributions are not. This distinction means that when an employee withdraws employer contributions in retirement, these contributions are then taxed.
Rollovers
Employees can roll over contributions from a Roth 401(k) to a Roth IRA or another Roth 401(k). Additionally, employees can rollover contributions from a governmental 457(b), 403(b) or another Roth 401(k) to your company's Roth 401(k). The only acceptable method for moving nontaxable distributions between 401(k) accounts is a direct trustee-to-trustee transfer.
Taxes
All Roth 401(k) contributions are made after taxes are taken out of an employee's income. This setup is the exact opposite of traditional 401(k) contributions, which are tax-deferred and thus do not have taxes taken from them. Additionally, since Roth 401(k) contributions are taxed, they are not tax-deductible like other retirement plans.
Withdrawals from a Roth 401(k) are not taxed if an employee takes them under the following circumstances:
- The employee is at least 59½ years old.
- The employee is disabled.
- The account's beneficiary withdraws money after the employee's death.
In addition to the above criteria, withdrawals can only be tax-free if at least five years have passed since the employee's first contribution to the account.
Required distributions
Although employees can take tax-free distributions from their Roth 401(k) account from age 59½ onward, they aren't required to do so until they reach age 72. However, if the employee is still working and does not own 5% or more of your company, distributions are not required.
What are the benefits of a Roth 401(k)?
Although 401(k) accounts arguably benefit employees more than employers, both groups may find these retirement plans worthwhile for several reasons. These reasons include:
Benefits of Roth 401(k) plans for employees
- Tax-free withdrawals. In retirement, Roth 401(k) withdrawals aren't taxed. This model contrasts with the traditional 401(k) model, in which all retirement-age withdrawals are taxed as income. As such, Roth 401(k) accounts are especially beneficial for employees who expect to move into higher tax brackets as they grow older.
- More flexibility for penalty-free withdrawals. Roth 401(k) plans mostly lack the substantial penalties for early withdrawals often associated with SEP IRAs and SIMPLE IRAs. Instead, tax-free withdrawals can begin at age 59½, and disabled employees can take withdrawals at any age. Additionally, if an employee dies, their account's beneficiary can withdraw funds tax-free.
- No income limits. Anyone of any income can contribute to a Roth 401(k), which isn't true for a Roth IRA. This means that all your employees can participate in your Roth 401(k) plan.
- No matching rules. Unlike with SIMPLE IRAs, there is no minimum or maximum percentage of an employee's income that an employer must match. As a result, employees may be able to receive more in employer contributions with a Roth 401(k).
Benefits of Roth 401(k) plans for employers
- Happier employees. If your company offers Roth 401(k) plans, your employees may feel more satisfied and thus are more likely to stay with your company. The result is a lower employee turnover rate.
- Better hires. For the same reasons, offering Roth 401(k) plans may give you an advantage over your competitors when hiring employees. Job hunters interviewing for positions at several different companies may be more inclined to take your offer versus one from a competitor that doesn't offer retirement plans.
- Relatively inexpensive. Among benefit types, Roth 401(k) plans are relatively inexpensive. Whereas a health insurance plan, which is certainly the benefit that employees demand the most, may cost tens of thousands of dollars per year to administer, some Roth 401(k) plans cost less than $2,000. However, remember that SIMPLE IRAs and SEP IRAs may be less expensive than Roth 401(k)s.
Examples of a Roth 401(k)
Suppose that one of your employees earns $100,000 per year and is age 52. This employee has a maximum contribution limit of $19,500 plus a catch-up contribution limit of $6,500, so they can contribute up to $26,000 per year. Since their $100,000 income more than covers their cost of living, they do indeed contribute $26,000 during a certain year. However, since their income is taxed at 25%, they only contribute $19,500 to their account after taxes.
Let's say that another of your employees who is 29 years old and earns $60,000 has a 1% employee-matching contribution clause in their employment contract. If this employee contributes $2,500 to their Roth 401(k) during a certain year and is taxed at a rate of 20%, then they actually contribute $2,000. However, since employee-matching contributions are tax-deferred, you contribute $2,500. The employee's account thus totals $4,500 for the year.
Roth 401(k) vs. traditional 401(k)
The main difference between a Roth 401(k) and a traditional 401(k) is each plan's tax structure. With a Roth 401(k), deposits are taxed, which isn't the case with traditional 401(k)s. Additionally, Roth 401(k) withdrawals in retirement are not taxed, whereas retirement-age traditional 401(k) withdrawals are taxed as income.
In general, Roth 401(k) accounts offer more flexibility for your employees, since they allow for several types of tax-free withdrawals. Traditional 401(k) accounts, on the other hand, include more provisions that could lead to penalties for your employees.
To give your employees the option to choose between Roth 401(k) and traditional 401(k) accounts, you can offer a 401(k) plan, in which employees can designate some contributions as Roth and some as traditional. You can also offer SIMPLE IRAs or SEP IRAs. If you can't quite decide which option is best for your business, speak to your accountant or other financial experts.
You can also speak to your team to see what they want from their retirement benefits. Any plan that meets your employees' wants and needs is a good one, and for some companies, Roth 401(k)s might be the right option. To get started with one, consult our employee retirement plan reviews.