Posting by Scott Reddersen

With many employers now offering a Roth 401(k) component with their retirement benefits, you may be wondering which option works best for your retirement planning purposes. Like most questions involving tax planning matters, the answer is rarely straightforward.

In this post, we’ll look at the differences between Roth and traditional 401(k) plans, as well as Roth IRA and Roth 401(k) plans, and cover some of the tax consequences you may incur when using these retirement savings strategies.

Difference between Roth and Traditional 401(k) Plans

The primary difference between a Roth and a traditional 401(k) plan is the timing of when you pay tax on the money in the retirement plan. With a traditional 401(k), contributions are deducted on a pre-tax basis when made, so the tax on the contributions and any earnings is paid when you begin taking distributions, usually in retirement. With a Roth 401(k), it is just the opposite: the plan is funded with your post-tax dollars (there is no current deduction for contributions), meaning the distributions will not be subject to tax. In other words, while Roth 401(k) contributions provide no current tax benefit, the contributions plus earnings will never be taxed when you take qualifying distributions.

Therefore, an important factor will be whether you believe you’ll be paying tax at a higher or lower rate when you begin taking distributions. If you believe your tax rates will be lower in the future, a traditional 401(k) plan, which provides a current year reduction to income, may be more valuable. Alternatively, if you believe your rates will be higher in the future, a Roth 401(k) may be a good option—pay the tax now for the benefit of tax-free distributions later.

Difference between Roth IRAs and Roth 401(k) Plans

You may be wondering what the difference is between a Roth IRA and a Roth 401(k). While these plans share many of the same characteristics, there are some additional noteworthy differences between them:

Contribution Limits. The contribution limit for a Roth IRA (like a traditional IRA) is $5,500 ($6,500 if you’re 50 or older). The contribution limit to a Roth 401(k) matches a traditional 401(k) and allows you to contribute up to $17,500 ($23,000 if you’re 50 or older).

Income Limitations for Contributions. A Roth 401(k) is not subject to the income limitations for contributions that exist for Roth IRAs. To contribute to a Roth IRA in 2014, your modified adjusted gross income cannot exceed $191,000 (phase-out begins at $181,000) if you file married filing jointly, and $129,000 if you are single filer (phase-out begins at $114,000).

Required Distributions. Roth IRAs do not require distributions at any age, whereas a Roth 401(k) requires minimum distributions once you reach age 70 ½, which is similar to a traditional 401(k) or traditional IRA. Both Roth IRAs and Roth 401(k)s are subject to the “5 year rule,” which prohibits an investor from taking a qualified distribution until 5 years from the first day of the tax year in which the initial Roth contribution is made, meaning that you could face penalties and tax on distributions during that time frame. This rule applies regardless of age, so you should consider this if you are approaching 59 ½ and may need access to the funds in the short-term.

Retirement Planning with a 401(k) Plan, Roth IRAs, and Roth 401(k)s

It’s important to note that participating in one of the above does not necessarily preclude you from participating in another retirement savings vehicle. For instance, one strategy could be to make traditional 401(k) contributions if you are approaching the modified adjusted gross income limitation for Roth IRA contributions (see limits above). This would lower your adjusted gross income and allow you to also make contributions directly to a Roth IRA.

Another popular approach for those whose income exceeds the Roth IRA contribution limitations is to make a “back door” contribution. Essentially, you would make a nondeductible contribution to a traditional IRA, and then convert it immediately to a Roth IRA. Since there are no income limitations for Roth conversions, you would only pay tax on any earnings from the time of the initial contribution to the time of the conversion—usually a few days under this strategy. Note that this is not a good strategy for those who already have money in traditional IRAs because conversions are taxed on a pro rata basis of all IRAs, so you could unintentionally end up paying tax on the majority of the converted amount, and thus greatly reduce the benefit of this strategy.

As with any shift in retirement planning, is it important to discuss your current situation and future goals with your tax and/or investment adviser before making a determination on which strategy or strategies may be best suited for you. For more details on the differences and similarities of these types of retirement plans, visit the IRS website.