When you contribute to a 401k or 403b retirement plan, you can choose whether they’re pre-tax contributions or after-tax contributions.
If you choose pre-tax deferrals, your contributions get deducted from your taxable income. You get to pay less taxes the year you contribute, but you’ll have to pay taxes when you withdraw from your account in retirement.
Alternatively, you can choose to make after-tax Roth deferrals into a Roth account. You pay taxes on your income now, but you get to make withdrawals in retirement completely tax-free.
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What is a Roth deferral?
After-tax contributions made to a Roth retirement account using employee deferrals are considered Roth deferrals. You get no immediate tax benefits for Roth deferrals but, since the money’s already been taxed, you get tax-free withdrawals in retirement.
For example, if you contributed a total of $50,000 to your retirement account and it grew to $5 million in retirement:
- If you had contributed with pre-tax deferrals, your withdrawals in retirement are taxed based on your tax bracket and tax rates at the given time.
- If you had contributed with Roth deferrals, your withdrawals in retirement are completely tax-free. The entire nest egg is yours.
The most popular types of retirement plans that offer Roth deferrals are corporate 401k plans and solo 401k plans.
Difference between Roth IRA
A Roth deferral typically refers to employee deferrals. A 401k is an employer sponsored retirement account, while a Roth IRA is an individually owned account.
Therefore, Roth deferrals are classified differently than Roth IRA contributions. When speaking of Roth deferrals, it’s typically referring to retirement plan contributions within an employer sponsored retirement account.
Roth deferral limit for 2022
Roth accounts are separate accounts in a 401k or 403b retirement plan. Contributions are not excluded from gross income and are taxed based on your tax bracket.
For a 401k, employees can choose to contribute up to 100% of their compensation up to the maximum limit of $20,500 for 2022 ($27,000 if you’re over 50).
Employer Matching Rules
Only employee elective deferrals can be contributed to a Roth account. Employer matching contributions cannot be made to a Roth account, and will be treated as pre-tax contributions to a traditional account.
| Feature | Traditional Deferrals | Roth Deferrals |
|---|---|---|
| Contributions | Pre-tax. Contributions are not taxed, and are deducted from your taxable income. | After-tax. Contributions are taxed, and are not tax-deductible. |
| Who contributes? | Both employees and employers can make traditional 401k deferrals. | Only employees can make Roth deferrals to a Roth 401k. |
| Employer Match | Employer matches contributions to a traditional 401k. | Employer matches contributions, but they cannot go towards your Roth account. They get treated as traditional deferrals. |
| Contribution Limit | $20,500 for 2022 ($27,000 if you’ll be at least 50 years of age by December 31, 2022). | $20,500 for 2022 ($27,000 if you’ll be at least 50 years of age by December 31, 2022). |
| Taxes | Contributions are not subject to tax and get deducted from your taxable income for the year. | Contributions get taxed, and you get no tax deductions for the year. |
| Withdrawals | Taxed when you take qualified distributions. | Tax-free withdrawals. |
| Qualified Distributions | Can access the money when you reach the age of 59½. | Can access the money when you reach the age of 59½. |
| Required Minimum Distributions (RMD) | Must start taking distributions when you reach 72 years of age. | Must start taking distributions when you reach 72 years of age. |
Who should consider Roth deferrals?
You may want to consider Roth deferrals over traditional pre-tax deferrals if:
- You think you’ll be in a higher tax bracket in retirement.
- You expect your retirement account to grow significantly by the time you retire.
- You don’t need the tax deduction this year.
Retirement accounts like the solo 401k have tax-free compounding. If you start compounding your money from an early age, not having to pay any taxes on your gains can be a significant tax-savings in your retirement.
Roth deferrals might not make sense if:
- You need to a tax break for the year and getting an immediate tax deduction is important to you.
- You think you’ll be in a much lower tax bracket by the time by the time you retire.
- You don’t necessarily believe your retirement account will grow by a significant amount and wouldn’t mind being taxed on withdrawals.
Withdrawals on Roth deferred contributions
You can start taking qualified distributions from your retirement account when you reach the age of 59½. Withdrawals from a Roth account after you reach 59½ years old are excluded from your gross income and aren’t subject to taxes.
Withdrawals from Roth deferred contributions are tax-free. No matter how much your retirement account has grown, you’ll owe nothing in taxes. The entire nest egg is yours.
Penalties for early distributions
Withdrawals made before you turn 59½ years old are considered nonqualified distributions and will get hit with a 10% fee plus income taxes on the amount drawn.
Required minimum distributions (RMD)
Roth accounts have required minimum distributions (RMD). The IRS forces you to start taking withdrawals from your Roth account at the age of 72. How much you need to take in distributions can be calculated using the RMD table for 2022.
Rollover into a Roth IRA
A Roth 401k can be rolled over seamlessly into a Roth IRA, which does not have RMD rules.
- Rollovers from a Roth 401k to a Roth IRA are not a taxable event.
- Rollovers from a traditional 401k to a Roth IRA are subject to income tax.
Wrapping Up
Retirement plans like the solo 401k, corporate 401k, and the Roth IRA provide the option to make Roth deferred contributions.
Unlike traditional pre-tax deferrals, you pay taxes on your income now, but can withdraw from your nest egg tax-free in retirement. If you start compounding your money at an early age, and believe you’ll be in a higher tax-bracket later in retirement, the tax-savings can be significant.
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