When you contribute to a 401k or 403b retirement plan, you can choose whether they’re pre-tax contributions or post-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 post-tax Roth deferrals into a Roth retirement account. You pay taxes on your income now, but you get to make withdrawals in retirement completely tax-free.
What is a Roth deferral?
Post-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 2023
Roth accounts are separate accounts from your regular pre-tax 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 $22,500 for 2023 ($30,000 if you’re at least 50 years of age).
Employer Matching Rules
In the past, only employees were allowed to make Roth deferrals and 401k matches by your employer could only be made with pre-tax dollars. However, the SECURE 2.0 Act now makes it possible for your employer to make matching contributions to employees’ Roth 401k accounts.
| Feature | Traditional Deferrals | Roth Deferrals |
|---|---|---|
| Contributions | Pre-tax. Contributions are not taxed, and are deducted from your taxable income. | Post-tax. Contributions are taxed as regular income, and are not tax-deductible. |
| Who contributes? | Both employees and employers can make traditional 401k deferrals. | Both employers and employees can now make Roth contributions. |
| Employer Match | Employer matches contributions to a traditional 401k. | Under the new SECURE 2.0 Act provisions, employers can now choose to make 401k matches as Roth. |
| Contribution Limit | $22,500 for 2023 ($30,000 if you’ll be at least 50 years of age by December 31, 2023). | $22,500 for 2023 ($30,000 if you’ll be at least 50 years of age by December 31, 2023). |
| 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 withdraw the money without penalties when you reach the age of 59½. | Can withdraw the money when you reach the age of 59½. |
| Required Minimum Distributions (RMD) | Must start taking distributions when you reach 73 years of age. | No required minimum distributions are required for a Roth 401k. |
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.
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 401k accounts no longer have required minimum distributions (RMD) under the new SECURE Act 2.0 provisions.
Rollover into a Roth IRA
A Roth 401k can be rolled over seamlessly into a Roth IRA, which also 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 401k, solo 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.