One of the many reasons why the CFP® exam is so difficult is due to the volume of information that students must learn, retain and process during the educational journey. Another reason is the test writers for the Certified Financial Planner™ exam can take one topic, such as the Roth 401(k), and ask a number of difficult questions. IRA and 401(k) questions can be tough enough, but throw in after-tax contributions, early withdrawal penalties and RMDs, and you can be in for a long day.
To make the Roth 401(k) rules a bit more easily understood, let’s start with the basics and we’ll work in a few things to look out for as you continue with your CFP® exam prep.
What is a Roth 401(k)?
A Roth 401(k) is a Roth account associated with a 401(k) plan; the Roth account is called a designated Roth account.
Like a Roth IRA, contributions to a designated Roth account inside of a 401(k) are made on an after-tax basis. This means that there is no upfront tax benefit. Rather, contributions to a designated Roth account grow on a tax-deferred basis with the opportunity to withdraw funds in the account on a tax-free basis if certain requirements are met.
Note the term designated Roth account pertains to Roth accounts not only in a 401(k), but also in a 403(b) plan or a 457 plan.
How much can be contributed to a Roth 401(k) account?
Plan participants can contribute up to the annual deferral limits for a 401(k) plan to their designated Roth account. For 2022 this is $20,500 and $27,000 for those who are age 50 or over at any point during the calendar year.
It should be noted that any employer matching contributions must be made pre-tax to a traditional 401(k) account for the participant; employer contributions to a Roth 401(k) account are not permitted.
Qualified distributions
Distributions from a Roth 401(k) account will not be taxed as long as the criteria for a qualified distribution are met.
These criteria include:
- The plan participant has satisfied the 5-year rule
- The plan participant is at least age 59 ½
- Distributions are made by beneficiaries after the plan participant’s death
- Distributions are made due to the disability of the plan participant
If the withdrawal is made after age 59 ½ but prior to the fulfillment of the five-year rule, and not due to death or disability, the portion of the withdrawal attributable to earnings in the account will be subject to income taxes. The amount of the participant’s contributions to the account would not be taxed.
If the withdrawal is made prior to age 59 ½ but prior to the fulfillment of the five-year rule, and not due to death or disability, the portion of the withdrawal attributable to earnings in the account will be subject to income taxes and this amount would be subject to a 10% early withdrawal penalty as well. The amount of the participant’s contributions to the account would not be taxed.
The amount of an early withdrawal from the plan is generally prorated between earnings and non-taxable contributions to the account.
Required minimum distributions
Unlike Roth IRA accounts, Roth 401(k)s are subject to RMDs. The same age applies to these RMDs as any other retirement. Age 72 for those who turned 72 on or after January 1, 2020 or age 70 ½ for those who reached that age prior to January 1, 2020.
Plan participants who are still working and who are not 5% or greater owners of the employer can defer these RMDs until they leave the employer.
These RMDs can be avoided by rolling the balance in their designated Roth account over to a Roth IRA upon leaving the company. Note once the account is rolled over to a Roth IRA, the “clock” starts over on the five-year rule for this money.
Income limits
Unlike with a Roth IRA account, there are no income caps limiting a participant’s ability to contribute to the designated Roth account in their 401(k). They can contribute up to the limits for 401(k) salary deferrals for the year.
When it comes to answering questions related to IRAs, Roth IRAs, 401(k) and Roth 401(k) plans correctly, it’s absolutely vital that your CFP® exam prep in these areas is solid. Yes, there are a lot of retirement plan rules and yes, the CFP® Board will test you on many of these, but you don’t need to know every little detail. When it comes to plans like the Roth 401(k), you’ll want to draw similarities between it and other plans so that you maximize your time and comprehension of the different plans that exist.