Roth 401k Plans Explained: What You Need To Know

The ability to save in a Roth 401k has been around since the Pension Protection Act of 2006. This act allowed businesses (plan sponsors) to offer employees the option to defer their after-tax salary into an account that will allow for tax free withdrawals in retirement.

This tax-free concept for retirement was introduced a decade earlier with the creation of the Roth IRA in 1997. However, its use within 401k plans wasn’t allowed until 2006. Still, many 401k plans don’t make it an option for their employees.

To review, the most common type of employee salary deferral into 401k plans is from pre-tax dollars. In this pre-tax scenario, the employee elects to contribute a portion of their gross pay into the plan before taxes.

This allows a reduction in taxable income to the employee and thus, a lower annual tax bill. These contributions and the investment earnings are considered tax-deferred because they will be fully taxable upon withdrawal during retirement.

While pre-tax contributions reduce your tax bill now, you will eventually pay tax on the withdrawals in the future. With after tax contributions into this plan, you don’t get the reduction in taxable income, but the earnings are exempt from taxation and future withdrawals are tax free! Please review my prior post titled Tax-deferred vs. Tax-free for more information on this subject.

Is a Roth 401k better than a traditional 401k?

It’s nearly impossible to say which plan is better. Instead, think of it in terms of pros and cons. It’s also a good idea to not think of them as separate plans. Instead, having Roth provisions in your employer sponsored plan is like an add-on.

If you’re serious about financial planning, you should absolutely consider making it part of you retirement strategy. Remember, much of this depends on your specific situation, consider your tax rate, and consult a tax professional.

Employers are not required to offer these plans:

The Pension Protection Act of 2006 (PPA) simply allowed employers (plan sponsors) to make this option available. It isn’t mandatory and many employers aren’t proactive in making changes to their plan. Employers often won’t make changes unless they are required to.

Other times, a little bit of nudging by key employees can help motivate employers to improve benefits. If you’re an employer or 401k plan trustee, make sure to review your plan and consider making Roth 401k options available.

If your plan doesn’t have Roth provisions, you need to make sure your voice is heard and ask for it. 401k plans are not always top of mind for employers. In fairness, employers are often inundated with compliance related issues that pertain to retirement and other benefits.

They might be reluctant to add one more layer to an already complicated plan. Despite this, be sure to talk about it with other employees and those in charge of the plan. At the end of the day, employers are well served by offering quality retirement plans to employees.

Roth 401k plans have no income limitation:

Roth IRAs, the more typical and commonly known tax-free retirement accounts, limit contributions based on income. Many people are surprised to find they aren’t eligible to contribute to a Roth IRA because their income is over the IRS imposed limit.

The annual contribution limits in 2025 are $7,000 and $8,000 for those age 50 or older. However, that contribution limit can be substantially reduced or even eliminated due to the MAGI (modified adjusted gross income) phase out range.

With a Roth 401k, there is no income limitation and the contribution limit is substantially higher than for Roth IRAs. Why is this important? If you’re not eligible to contribute to a Roth IRA, you could contribute to a Roth 401k.

There is a lot of confusion and misunderstanding about this. I regularly hear people say they can’t participate due to their income. This simply isn’t the case.

You will still have before tax dollars:

I’m often asked, “will a plan like this minimize the income tax I pay?” The answer is, “it depends.” It is important to remember that your 401k plan has several funding sources. Without getting stuck in the weeds, 401k is simply the section of the IRS code that allows employees to contribute their own money to their employer’s profit-sharing plan. When we use the general term “401k” to describe these plans, we’re really talking about a profit-sharing plan.

As a result, regulations require the source of funds in a profit-sharing plan to be tracked and accounted for. When you get your retirement plan statement, the sources should be broken out between employee contributions (salary deferral), company matching contributions, and profit sharing contributions.

Be sure to get familiar with the concept of tax-deferred vs. tax-free investment accounts. Even if your plan allows after tax dollars, you will still have to pay taxes on the other sources of funds. And remember that after tax dollars will be included in your annual income taxes.

Why is this important? When you elect to make salary contributions, the company matching and profit-sharing contributions will still be tax deferred. Stated another way, the portion of your account attributable to employer contributions will be taxable when you withdraw money. Those funds are accounted for separately and will be taxable when future withdrawals are made from the account. That includes state income taxes.

Required Minimum Distributions or RMDs:

Most retirement plans are subject to IRS rules that require individuals to begin withdrawals from their retirement plans when they reach age 73. These are known as Required Minimum Distributions or RMDs. Because Roth IRAs are exempt from the IRS RMD rules, many mistakenly believe Roth 401k plans are exempt as well. Unless you rollover your Roth 401k to a Roth IRA, you will be subject to the RMD rules.

It is important to note that inheriting retirement accounts is a whole other discussion when it comes to RMDs. There are separate rules that pertain to inheriting various types of retirement accounts. Further, your relation to the decedent and when you inherited the funds muddy the water even further. If you find yourself inheriting retirement funds, be sure to reach out to a Certified Financial Planner™ professional to guide you.

In-plan Roth rollovers:

These are rollovers from the pre-tax portion of your 401k which include elective deferrals (salary contributions), matching contributions, and profit sharing contributions to the Roth 401k. This will result in taxable income in the year of the transaction.

It is important to remember that just because you can do something, it doesn’t mean you should. If you are in a retirement plan that offers in-plan Roth rollovers, there is no opportunity for a “do-over” so plan carefully.

While Roth IRA conversions used to allow a period of time for a “do-over” that is no longer the case. If you are considering a transaction like this, you should proceed with caution.

After-Tax Contributions

Some 401k plans allow after-tax contributions with limits far beyond the typical salary deferral range. Usually, participants are subject to the salary deferral limit when making pre-tax or Roth contributions. In 2025, that limit is $23,500 or $31,000 for those 50 or older as a “catch-up.”

SPECIAL NOTE: Beginning in 2025 there is a higher catch-up contribution limit for employees age 60 through 63. Employees who participate in 401(k), 403(b), and 457 plans in that age range can contribute an additional $11,250.

However, after-tax contributions are subject to the total contribution limit of $70,000 ($77,500 as a catch-up). The total profit-sharing limit is based on employee salary deferral, company matching, and profit-sharing contributions combined.

While the after-tax contributions aren’t always ideal, they do play an important role for the Mega Backdoor Roth strategy.

Mega Backdoor Roth

While not common, some plans allow both after-tax contributions and the ability to do in-plan rollovers. This opens the door for a complex tax planning strategy known as the Mega Backdoor Roth.

This strategy involves making after-tax contributions to the 401k and then converting those funds into the Roth portion of the plan. This allows high income earners who aren’t eligible for Roth IRA contributions to contribute significantly higher amounts than utilizing a typical Backdoor Roth IRA strategy.

There are many moving parts to implementing both the Mega Backdoor Roth and Backdoor Roth IRA strategies. Be sure to consult a professional before taking this on.

Conclusion

These plans can be a great way to build a nest egg of tax-free funds for retirement. Consider how much of your portfolio will be subject to income tax during retirement. These plans help address that. No one can accurately predict where tax rates will be in the future, but having a portion of your nest egg that is tax free can reduce your taxes and give you more financial options during retirement.

Have you considered how a Certified Financial Planner™ can help you?

Schedule a call with me via this link!

Image courtesy of FreeDigitalPhotos.net