A Common Misconception About the Roth 401(k)

Image via Andrey Grushnikov

Roth 401k’s can be a very effective retirement planning tool to help individuals grow their retirement portfolio. However, any employer contributions to your Roth are subject to taxation upon withdrawal. The following article by the Center for Retirement Research provides more details about this common misconception.

Financial experts and writers often tout the Roth 401(k)’s main selling point: when the money is withdrawn in retirement, it won’t be taxed.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 Employer contributions and any resulting investment earnings are taxed as income in the year that the money is withdrawn.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.