Contributing to a Company Roth 401(k) Account

Does your company give employees the option of contributing to a designated Roth account (DRA)? Roth retirement plan options, such as Roth 401(k)s, are now offered by 88% of employers, according to the latest available statistics from 2022.

If your company offers DRAs, you should consider contributing to one, particularly if you expect to pay higher federal income tax rates during retirement than you currently pay. Here's what you need to know.  

Traditional vs. Roth 401(k)s

If your company allows you to make elective contributions out of your salary to a 401(k) account, the plan may include the DRA option. DRAs can also be offered by 403(b) and 457(b) plans. But this article focuses on employer-sponsored 401(k) plans that offer DRAs.

When you contribute to a regular 401(k) account, the contribution reduces your taxable salary and your federal income tax bill. Your state income tax bill is reduced, too (if applicable).

In contrast, when you contribute to an employer-sponsored Roth 401(k), you're taxed on the contribution as if it was included in your salary. The payoff is that earnings in your DRA are allowed to accumulate federal-income-tax-free. Then you can eventually take federal-income-tax-free qualified withdrawals from the account.

In general, a qualified withdrawal is one taken after:

• Your DRA has been open for more than five years, and
• You're age 59½ or older.

Qualified withdrawals can also include withdrawals after becoming disabled or withdrawals taken by an account beneficiary after the account owner has passed away. Your employer must keep your DRA funds in a separate account that can be rolled over into either your own Roth IRA or another company plan that permits DRAs.

Contribution Limits

There are no income-based limits on your ability to contribute to a DRA. For 2024, you can contribute up to $23,000. The contribution limit increases to up to $30,500 if you'll be age 50 or older as of December 31, 2024.

Your employer also can make matching contributions— but these must go into your regular 401(k) account, and later withdrawals from that account will be taxable. That said, employer matching contributions are always beneficial because they're "free money."  

Two Critical Factors

Consider the following two key factors when evaluating the DRA option:

1. The longer you hold funds in a DRA, the better, because you can build up a bigger federal-income-tax-free retirement fund. For that reason, DRAs are especially attractive to younger retirement savers.
2. The higher the tax rate you expect to pay during your retirement years, the bigger the DRA advantage will be.

For instance, say your DRA contributions would be taxed at a 22% federal rate, and you expect to be in the 35% tax bracket in retirement. The option of taking future tax-free DRA withdrawals is worth more than the current tax cost of making DRA contributions.

DRA Contributions vs. Roth IRA Contributions

Should you contribute to your employer's DRA or your own Roth IRA? You might be able to do both, but there are income limitations on your ability to make annual Roth IRA contributions.

For 2024, the maximum annual contribution to a Roth IRA is $7,000 ($8,000 if you'll be 50 or older as of December 31, 2024). For 2024, your ability to make an annual Roth IRA contribution begins to be phased out once your adjusted gross income (AGI) exceeds $146,000 if you're unmarried ($230,000 if you're married and file jointly). Your ability to contribute is completely phased out once AGI reaches $161,000 if you're unmarried ($240,000 if you're married and file jointly). 

In contrast, there are no income limits on your ability to make DRA contributions. And, for 2024, you can contribute up to $23,000 (up to $30,500 if you'll be age 50 or older as of year end). So DRA contributions are potentially much more beneficial than Roth IRA contributions.

However, there are some downsides to DRAs. While you have complete control over your own Roth IRA, that's not true with a DRA. Your company's plan will have limited investment options. In addition, you generally can't take money out of a DRA until you leave the company, unless you qualify for a hardship distribution.

If your income permits, you can contribute to your own Roth IRA and then contribute to your company plan DRA. That way, for 2024, you can potentially contribute a combined total of up to $30,000 ($7,000 plus $23,000). If you'll be 50 or older at year end, you can potentially contribute a combined total of up to $38,500 for 2024 ($8,000 plus $30,500).

Important: Until recently, DRA participants were required to take annual required minimum distributions (RMDs) from their accounts. That changed under the SECURE 2.0 Act, which was enacted late in 2022. Beginning in 2024, this change puts DRA participants on an equal footing with Roth IRA owners by exempting DRA participants from the RMD rules for as long as they live.

In-Plan Rollovers

If your company's 401(k) plan allows DRAs, it may also allow you to roll over funds from your regular 401(k) account into a DRA. This is a so-called "in-plan rollover." It's the quickest way to get a large amount of money into your DRA. But the amount you roll over will be taxed, because it's effectively treated the same as a Roth IRA conversion transaction.

Important: If you withdraw rolled-over DRA funds within the five-year period starting on the first day of the year in which you executed the rollover, you can get hit with a 10% early withdrawal penalty tax unless an exception applies.        

Rolling over a DRA into Your Roth IRA

When you leave the company, you can roll over your DRA balance into a Roth IRA. That's generally recommended, because you won't have to take any annual RMDs from the Roth IRA for as long as you live.

The account balance can continue earning tax-free income, which will result in significant tax-free withdrawals after age 59½. If you still have a balance in your Roth IRA when you pass away, whoever inherits the account can take tax-free withdrawals after meeting the rules for qualified withdrawals.

Catch-Up Contributions and DRAs: Stay Tuned for Changes

If you're age 50 or older, you can turbo-charge your retirement savings by making extra "catch-up" contributions if your company's plan allows them. The SECURE 2.0 Act made two significant changes to the catch-up contribution rules.

First, it increases the limits on catch-up contributions for those ages 60 to 63, beginning in 2025. Under this provision, the maximum catch-up contribution will increase to the greater of:

• $10,000 (adjusted annually for inflation), or
• 150% of the maximum inflation-adjusted "regular" catch-up contribution for 2024.

For 2024, the maximum regular catch-up contribution is $7,500. So, for 2025, the maximum catch-up contribution will be at least $11,250 (150% times $7,500).

To clarify, these "bonus" catch-up contributions will only be allowed for plan participants who reach ages 60 to 63 during the year in question. For all other eligible participants, the "regular" catch-up contribution maximum will continue to apply.

The second major change under SECURE 2.0 would have affected plan participants in 401(k), 403(b) and 457(b) plans whose prior-year wage income exceeds $145,000 (adjusted annually for inflation). Starting in 2024, according to the SECURE 2.0 statutory language, these higher-income participants will only be able to make catch-up contributions to designated Roth accounts (DRAs). These contributions are made after-tax, so they don't reduce your taxable salary. The advantage is that DRA balances can grow free from federal income tax, and qualified distributions taken from DRAs are federal-income-tax-free.

The IRS postponed the second change to the catch-up contribution rules until 2026, in response to various stakeholder concerns and the 2024 effective date. Therefore, until 2026, employers can ignore this change, and higher-income employees can continue making catch-up contributions to eligible regular retirement plan accounts.

What's Right for Your Situation?

If your company's plan includes the DRA option, give it a hard look. It could be especially beneficial if 1) your company's plan matches DRA contributions, 2) your income is too high to make annual Roth IRA contributions, and/or 3) you expect to pay higher income tax rates in retirement than you currently pay.

Also, consider making an in-plan rollover into a DRA if your company's plan includes that option. Keep in mind that there's a tax cost for making an in-plan rollover. Contact your advisor before rolling over significant amounts to make sure you fully understand the tax consequences.

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