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Know About the Roth 401(k) Surprise?

Financial experts and writers often tout the Roth 401(k)’s main selling point: when the money is withdrawn in retirement, it won’t be taxed.

Well, that’s not entirely true.

An employee’s own money saved in his Roth account over the years is, indeed, shielded from income taxes when he retires and starts pulling out the money. That’s because the worker had paid the taxes before he put the money into the Roth.

But employer contributions to Roths are different. Employer contributions and any resulting investment earnings are taxed as income in the year that the money is withdrawn.

“Most everyone I talk to is shocked by this and surprised,” said CPA Sean Stein Smith, a business and finance professor at Lehman College in New York. Understanding the difference between the two types of savings plans offered to employees – Roth versus regular 401(k) – is already complicated enough, he said, and the tax distinction only adds to the confusion.

The reason withdrawals of employer contributions to Roths are not exempt from income taxes is because they are no different than employer contributions to regular 401(k)s. They are another form of income, just like your hourly wages. However, no taxes are deducted from a worker’s paycheck for Roth and regular 401(k) contributions when the employer puts them into the account. So the worker eventually has to pay the taxes – they are simply being delayed.

The next logical question is, how do you know how much you owe in taxes? What if you withdraw retirement income from both a Roth and a traditional 401(k) over the course of a year?

Figuring out the tax bite “is not your problem,” said Jaleigh White, CPA for a Louisville, Kentucky, investment firm and member of the National CPA Financial Literacy Commission for the American Institute of CPAs.

Retirees with two accounts decide which one to withdraw money from. But the investment firm administering and investing your 401(k) is responsible for tracking the returns and contributions to each account and can immediately estimate how much you would owe in income taxes, depending on which account the money comes out of. In the case of the Roth, the taxes hinge on whether it is coming out of the employer or employee side of the equation.

Smith nevertheless advises retirees to plan their 401(k) withdrawals ahead of time, to make sure they know what the taxes will be.  An accountant can estimate and compare the impact of different withdrawal strategies in the upcoming tax season, based on where the money comes from, he said.

If “you don’t want to be surprised” at tax time, Smith said, plan ahead.

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5 Responses to Know About the Roth 401(k) Surprise?

  1. Diana says:

    Thank you for the article. It is very important to plan ahead for your retirement and estimate the taxes that you’ll be paying. Each source of income you receive in retirement, will have different tax implications – for example, portions of Roth 401k distributions should be exempt from ordinary income taxes, while more traditional retirement distributions will be subject to income tax in their entirety. Your tax rate will depend upon your income and deductions in retirement.

  2. RetiredAt49 says:

    Yikes! What about those who rolled the whole 401(k) into their respective IRAs years ago? Oh no.

  3. Brett Layton says:

    I am 60 and was out of the corporate game in my mid-fifties. So I was not able to fully enjoy the ROTH 401k option. I am in the gig economy now and building a ROTH account, but not significant dollars.

    Tax location is critical to managing your taxes in retirement. Traditional IRAs and 401K produce ordinary income, Roth are tax free (except for employer matches which are maintained in a standard 401K account). After tax portfolios are taxable upon sale. Long-term capital gains and qualified dividends are taxed at preferential rates. Taking loans either margin loans (not recommended) or equity loans against your house are tax free, but the interest may not be deductible.

    Putting all these pieces requires time and attention, but it is doable.

    Never put yourself in a higher tax bracket if you do not need the cash, and never let a lower tax bracket go to waste by not filling it.

    Managing your taxes carefully can extend the life of your pile of capital.

    The unexpected occurs, but not planning at all is planning to fail in all endeavors.

  4. Retirementplanguru says:

    This terminology used in this article makes it more complicated than it actually is. First of all, there are no such thing as “employer contributions to Roths” so there is no need to determine whether it will be or won’t be taxable at distribution. Employees can make Roth 401k contributions; but employer contributions are either profit sharing or matching contributions. There is no such thing as a Roth profit sharing or Roth matching contribution.

  5. Kelley Long says:

    Another possible surprise is that if your Roth 401k is less than 5 years old, even if you’re over age 59 1/2, any withdrawals will be taxed. Unlike the Roth IRA, where the 5 year clock starts ticking with your first contribution, regardless of how many accounts you have, if you switch jobs in the years leading up to retirement and start a new Roth 401k right before, that 5 year clock restarts. Just a word of caution for those who are new to Roth 401k right before retirement.

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