Understanding the difference between Roth and after-tax contributions
If your employer offers Roth elective deferrals through your retirement account, there are potential savings opportunities worth considering. The decision to choose this option over the more traditional pre-tax approach (or a combination of both) is a personal one—based on your current and future circumstances.
How does a Roth Elective Deferral work? Unlike traditional tax-sheltered contributions, Roth 403(b) or 401(k) elective deferrals are a form of after-tax contribution. The money you contribute to your retirement plan is subject to federal, state and Social Security tax before it is invested, but it grows tax-deferred until you take it out at retirement. If it is withdrawn as a qualified distribution, it is completely free from federal (and in most cases state) tax at that time.
How is this different than after-tax contributions which have been available in the past? Both Roth elective deferrals and after-tax contributions are similar in tax treatment initially and during the years before retirement. The primary difference involves tax treatment for withdrawals. At retirement, qualified distributions of Roth funds are tax-free whereas withdrawals of after-tax contributions will have taxes due on the earnings. Another difference involves liquidity — after-tax contributions are not subject to the same distribution restrictions as Roth elective deferrals (i.e., Roth elective deferrals are only available at death, disability, separation of service, attainment of age 59 ½ or hardship).
How much can I contribute? In 2016, you can potentially contribute up to $27,000 to a Roth 403(b) as follows:
- $18,000 (general plan limit), plus
- $6,000 (if you are age 50 or older), plus
- $3,000 if you qualify for the 15+ years of church-related service increase (403(b) plans only).
This limit is a combined limit that includes any tax-sheltered contributions you may make. In other words, if you are eligible to contribute $24,000 and contribute $10,000 as tax-sheltered contributions, you can contribute $14,000 as Roth elective deferrals.
How do distributions work? Distributions from a Roth 403(b) or 401(k) are tax-free for federal income tax purposes (state tax rules vary by state) provided they are qualified distributions. To be a qualified distribution, accumulations must be held for a five-year period, and the withdrawal must meet one of the following conditions:
- Be taken on or after age 59 ½
- Be taken as a result of permanent disability or death
What are the benefits of Roth Elective Deferrals? The main benefit of the Roth 403(b) and 401(k) is tax related, and it is ultimately achieved at retirement. With Roth elective deferrals, the money that you have accumulated through your retirement plan will not have federal income tax (or state in many cases) due at distribution if qualifications are met.
Who should consider Roth Elective Deferrals? The decision to make Roth elective deferrals is personal but, in general, people who expect that their future retirement income will place them in a higher income tax bracket may benefit from this type of deferral. On the other hand, if you think your post-retirement tax bracket will be lower than your current tax bracket, you may be better off making tax-sheltered contributions.
Remember that choosing the type of contribution method that is right for you does not have to be an either/or decision—you can use a combination of both options. For more help deciding which method is best for you, utilize our convenient calculator.