Roth 401(k) plans are finally catching on.
More than half of the 400 large and mid-sized companies surveyed by benefits firm Aon Hewitt now offer a Roth 401(k) option to workers.
Roth 401(k)s can be great, especially for younger employees who have decades to let their account balances grow, and don’t care about an immediate tax deduction. Employee contributions to a Roth 401(k) are not tax-deductible, making them better for younger workers still in low tax brackets.
But there is one small complication with Roth 401(k)s that many employees don’t understand.
Even worse, we’ve already run across employers who are unaware of this issue, and provide incorrect paperwork to employees, creating the potential for expensive tax headaches down the road.
Here’s where it comes into play:
Your employee contributions to your company’s Roth 401(k) plan are true Roth contributions. They are non-deductible and are made from salary that has already been taxed. That means that when you withdraw your funds many years later, they are tax-free.
But employees (and employers) don’t often understand that employer contributions are different. They are tax-deductible to the company and are made with pre-tax dollars.
If you resign and move to another company, as many workers do, your Roth contributions and Roth earnings can be rolled into a personal Roth IRA. They retain their characterization as “Roth dollars.”
But the portion of your account that stems from the company match, and all its earnings, can only be rolled into a Traditional IRA account. They remain as pre-tax dollars and will be taxed when you ultimately withdraw them.
Why does this matter?
Some employer rollover forms we’ve seen recently fail to recognize that your Roth 401(k) rollover needs to be split into two pieces and directed into two different types of accounts – an after-tax Roth IRA and a pre-tax Traditional IRA.
Doing your rollover incorrectly can cost you in taxes and penalties, so make sure your employer’s procedures recognize these rollover “quirks” unique to Roth 401(k)s.