The Advantages of Roth After-Tax 401k Deferrals

Posted on Jan 29, 2022

When a 401k plan includes a Roth option, participants who are eligible to make traditional pre-tax 401k deferrals are also eligible to make Roth after-tax 401k deferrals. Roth after-tax 401k deferrals are popular because participants pay taxes on their deferrals at personal income tax rates during the year they are made, and qualified distributions and earnings at retirement are tax-free.  A “qualified distribution” is a distribution that is made:

• at least 5 years after the first contribution to the Roth account; and
• after the participant is age 59½, or on account of being disabled, or to a beneficiary after death.

Traditional pretax 401k deferrals reduce taxable wages, but eventually taxes must be paid on the deferrals and earnings once they are withdrawn. While it’s impossible to predict what future tax rates will be - or even necessarily what one’s future income will be - good candidates for Roth after-tax 401k deferrals are young workers with high income potential, or high earners who can afford to pay the taxes on their Roth deferrals upfront. There are no income limits for Roth after-tax elective deferral contributions, unlike the income limits for those making Roth IRA deferrals.

For 2022, the amount of Roth after-tax 401k contributions is $20,500 or $26,500 if the participant is allowed to make catch-up contributions. Making a traditional pretax 401k deferral and Roth after-tax 401k deferral in the same calendar year is allowed, but the total sums must not exceed the contribution limit of $20,500 or $26,500.

In a nutshell, a Roth after-tax 401k deferral allows plan participants to pay taxes now on their contributions if they expect to be in a higher tax bracket upon retirement. However, they must also consider whether traditional pretax 401k deferrals make more sense. Will they need to make withdrawals from their Roth account before the 5-year participation requirement? Can they contribute enough in their plan and still meet an employer match? With traditional pretax 401k deferrals, tax advantages are immediate because they reduce taxable W-2 income. Moreover, many people have a lower tax rate when they retire than when they were working, so they may come out ahead by paying taxes years later.

With many unknowns, the answer for some plan participants is to hedge their bets and make both traditional pretax 401k deferrals and Roth after-tax 401k deferrals.

This material is provided for informational purposes only, and is not intended as authoritative guidance, legal advice, or assurance of compliance with state and federal regulations.