How exactly is a Roth 401(k) taxed? The essence is that you don't get a tax deduction when you contribute part of your pay to it, just as you get with a traditional 401(k). Instead, a Roth 401(k) allows employees to contribute after-tax dollars. The payoff is that this money and its earnings over the years are not subject to income tax when you withdraw it after retiring.

These plans have only been available since 2006, but they are gaining in popularity as a way to establish a retirement income that is free from tax liability. 

Not all company-sponsored retirement schemes offer a Roth 401(k), but the number of plans offering Roth in 401(k)’s has increased in the last years, being especially popular among younger participants and contributions.

Let's take a look at the tax nuances of Roth 401(k)s and how they differ from a traditional 401(k) and a Roth IRA.

A Closer Look at Taxes and Retirement

Before you make the Roth 401(k) choice, consider the following tax consequences.

The Paycheck Hit

In any qualified retirement account, including the traditional and Roth 401(k), no additional tax is due from year to year while the funds stay in the account.

The immediate downside for participants in a Roth 401(k) is that the taxes on the income paid into the account are due that year. One of the biggest benefits of the traditional 401(k) is that it postpones the income tax on that money until years down the road when the account owner withdraws it after retiring.

Moreover, the money paid into the traditional account is deducted from the person's gross income. Effectively, that means lower immediate income taxes paid, offsetting part of the contribution.

The Tax Hit After Retiring

The point of either type of account is to provide the saver with a source of income after retiring. And there are big differences in the way each type of account is taxed:

• If it is a Roth account, all the taxes owed have already been paid. No further income taxes are due on either the contributions or the profits they earned over the years.
• If it is a traditional account, taxes are owed on both the contributions and the earnings.

Employer Contributions

An employer may offer a matching contribution for either a Roth or a traditional 401(k). Not all employers do, but some will match up to 5% or more of the employee's contribution.

In either case, the employer match is pre-tax money. The amount contributed will be subject to income tax when it is withdrawn after retiring.

You might consider this a minor issue since the rest of your Roth account is tax-free. It might even be an advantage, offsetting the amount you owe for taxes on all of your income.

No Income Restrictions (Unlike a Roth IRA)

A major tax advantage of a Roth 401(k) is the opportunity for higher-earning individuals to contribute more dollars into a retirement account that will be tax-free at retirement. Higher-income individuals do not qualify to open a Roth IRA, but they can contribute to a Roth 401(k).

For the tax year 2023, the annual income limit for contributions to a Roth IRA is a modified adjusted gross income (MAGI) of $153,000 for singles with a phase-out starting at $138,000. For those married filing jointly, MAGI must be less than $228,000, with phase-outs starting at $218,000.

For 2024, the MAGI limit rises to $161,000, with a phase-out starting at $146,000, for single filers. For those married filing jointly, the MAGI must be less than $240,000, with a phase-out starting at $230,000.

The Roth 401(k) has no such income restrictions. Contributions are, however, limited to $22,500 per year for the tax year 2023 (rising to $23,000 for 2024), with another $7,500 for participants over the age of 50 (remaining $7,500 for 2024). These are the same amounts permitted for contributions to a regular 401(k).

Required Minimum Distributions

There's a difference between how annual required minimum distributions (RMDs) are handled for a Roth 401(k) compared to a Roth IRA.

Roth IRAs do not mandate RMDs during the lifetime of the account holder. Roth 401(k)s did for 2022 and 2023, but not for 2024 and after. The good news is that the money is not taxable, unlike the money you take from a traditional 401(k). Even better, because Roth 401(k) distributions are not taxable, they have no impact on the taxability of your Social Security benefits

The removal of the RMD requirement is also beneficial because once you take a distribution from your Roth 401(k), that money cannot continue to grow tax-free. Now you can let it grow in your Roth 401(k) account until you are ready to withdraw funds.

The Bottom Line

The benefit of a Roth 401(k) and any Roth account is that earnings are not taxed and because you already funded the account with after-tax dollars, you won't be taxed when you withdraw funds. A Roth account can be a great way to enhance your retirement strategy, particularly if you have other retirement accounts where you will need to pay taxes when you withdraw funds, such as a traditional 401(k).