The 2015 Individual 401k contribution limit is $53,000 and $59,000 if age 50 or older (2014 limit is $52,000 and $57,500 if age 50 or older). The annual contributions into an Individual 401k consists of 2 parts, a salary deferral contribution and a profit sharing contribution.
Roth 401k Salary Deferral
Participants in an Individual 401k have the option to make Roth 401k contributions only with the salary deferral portion of the Individual 401k. In 2015 the Roth 401k salary deferral contribution limit is $18,000 and $24,000 if age 50 or older (2014 salary deferral limit is $17,500 and $23,000 if age 50 or older). Individual Roth 401k salary deferral contributions are not tax deductible, but withdrawals are tax free after age 59 ½ provided the 5 year rule is satisfied.
A profit sharing contribution of up to 25% of compensation can also be made into an Individual 401k. The profit sharing portion of the Individual 401k contribution is not eligible to be made as a Roth contribution. Profit sharing contributions are made pre-tax and are tax deductible.
Note: The combined 2015 salary deferral and profit sharing contributions in an Individual 401k cannot exceed $53,000 and $59,000 if age 50 or older (2014 limit is $52,000 and $57,500 if age 50 or older).
Roth 401k versus Traditional 401k comparison
|Roth 401k (after tax contributions)||Traditional 401k (pre-tax contributions)|
|Maximum annual contribution (under age 50)||$18,000 - 2015||$18,000 - 2015|
|Maximum annual contribution (age 50 or older)||$24,000 - 2015||$24,000 - 2015|
|Tax treatment of contributions||After tax (not tax deductible)||Pre-tax (tax deductible)|
|Tax treatment of distributions||Distributions are tax free if five years have passed since the first contribution AND there is a qualifying event (attainment of age 59½, death or disability)||Distributions are taxed as ordinary income and can be withdrawn after age 59 ½ without IRS penalty.|
|Required minimum distributions (RMDs)||Must begin at age 70½ unless rolled to a Roth IRA. If rolled over to an Roth IRA then the money is not subject to RMD rules until the death of IRA owner||Must begin at age 70½|
|Rollovers||Can rollover to another Roth 401k or a Roth IRA||Can rollover to another traditional 401k or a Traditional IRA or Rollover IRA|
What is a Roth Individual 401k?
The Roth Individual 401k is a retirement plan for the self employed that allows non tax deductible salary deferral contributions that grow tax free and are withdrawn tax free at retirement. Starting January 1, 2006, the Roth 401k salary deferral option became available in an Individual 401k. This plan known as a "Roth Individual 401k" combines features of Roth IRAs, but with higher contribution limits.
What are the differences between making pre-tax versus after-tax (Roth) contributions in my Individual 401k?
Individual 401k salary deferral contributions can be made as Roth 401k (after tax) or Traditional 401k (pre-tax).
The basic difference between a Roth 401k and a Traditional 401k is that the Roth 401k is funded with after-tax contributions while the Traditional 401k is funded with pre-tax contributions. In other words, with a Roth 401k you pay taxes today in return for a tax-free withdrawals in retirement. Traditional 401k contributions are tax deductible and are made pre-tax so you save taxes today, but withdrawals are taxed in retirement. As a result, the choice between the two 401k options comes down to whether you believe your income taxes rates will be higher or lower in retirement. If you believe your income tax rates will be higher at retirement then making Roth 401k contributions may be more advantageous. Also, there may be some estate tax benefits of a Roth 401k because in the case of death, the Roth 401k assets are tax free to your heirs.
How is the Roth Individual 401k different from a Roth IRA?
A Roth Individual 401k is similar to a Roth IRA because it allows after-tax contributions to grow tax-free until retirement when they are withdrawn tax free. However, a Roth Individual 401k allows much higher annual contribution amounts than a Roth IRA. In 2015 a Roth IRA has a $5,500 limit and $6,500 limit if age 50 or older. The 2015 contribution limit for the Roth Individual 401k is $18,000 and $24,000 if age 50 or older.
What are the advantages of the Roth Individual 401k over the Roth IRA?
- Regardless of income, everyone qualifies for a Roth Individual 401k. In 2015, you can’t fully contribute to a Roth IRA if your adjusted gross income exceeds $183,000 if you file a joint tax return with your spouse. If you are married filing jointly and your earned income is between $183,001 and $193,000, your 2015 Roth IRA contribution limit phases out. In 2015, you can’t contribute fully to a Roth IRA if your adjusted gross income exceeds $116,000 if you file as single or head of household. If your earned income is somewhere between $116,001 and $131,000 then your 2015 Roth IRA contribution limit phases out.
- Higher contribution limits are permitted with a Roth Individual 401k than a Roth IRA. For 2015 participants can contribute up to $18,000 to a Roth 401k ($24,000 if age 50 or older), but they can only contribute $5,500 ($6,500 if age 50 or older) into a Roth IRA.
How much can I contribute to a Roth Individual 401k annually?
The 2015 Roth Individual 401k contribution limit is $18,000 and $24,000 if age 50 or older (2014 limit is $17,500 and $23,000 if age 50 or older).
Can the profit sharing portion of an Individual 401k also be made with after-tax (Roth) contributions?
No. The profit sharing contribution cannot be made as a Roth contribution.
A profit sharing contribution of up to 25% of compensation can also be made into an Individual 401k. The profit sharing portion of the Individual 401k contribution is not eligible to be made as a Roth contribution. Profit sharing contributions are made pre-tax and are tax deductible. In 2015 the combined salary deferral and profit sharing contributions in an Individual 401k cannot exceed $53,000 and $59,000 if age 50 or older.
When can I withdraw from my designated Roth 401k account?
At age 59 ½, or later provided the 5 year rule is satisfied. An exception to the age 59 ½ rule occurs in the event of disability or death (in which case the proceeds are tax free to your heirs).
What is the “five-year rule”?
Assets may be withdrawn tax-free from a Roth Individual 401k provided the account has been established for five or more years and you are age 59 ½ or older. An exception is made in case of disability or death.
Who is best suited for a Roth Individual 401k?
The Roth Individual 401k is a new salary deferral option which is useful for a wide variety of people. See if any of the scenarios below apply to you.
1) You anticipate being in a higher income tax bracket in retirement than your current income tax bracket
If this is the case then it may make sense to make after tax Roth 401k contributions and pay income taxes now while in a lower tax bracket. Then while in retirement the assets can be withdrawn tax free when you are in a higher tax bracket.
2) You are relatively young and earn a lower income now, but expect to earn a much higher income and expect to be in a higher tax bracket in the future
If you expect your income to increase dramatically over your career, you may find contributing to the Roth feature today to be very advantageous, as you are in a lower tax bracket now than you will be in the future. Also, if you are many years from retirement, you could choose a Roth 401k as your best option as you expect your retirement plan to grow tax-free to a significant nest egg that can be withdrawn tax-free, more than compensating for the taxes paid when young and lower paid.
3) You had an usual year and your income decreased considerably and as a result you are in a lower tax bracket this year than your expected tax bracket in retirement.
You may want to take this opportunity to make Roth 401k contributions since you are in an usually low tax bracket this year.
4) Retirement investors who feel federal income tax rates will increase in the future
If you believe the government will increase tax rates in the future, then you may be better off making Roth 401k contributions and paying income taxes now. That way you would be paying taxes now at a lower tax rate and receiving the distributions federal tax free in the future at retirement when income tax rates are higher. Current income tax rates are low by historical standards.
5) You already have considerable assets in traditional pre-tax retirement accounts
In that case you may want to diversify your future tax liability and invest salary deferral contributions into the Roth 401k. That way some of your retirement nest egg can be withdrawn tax free at retirement. That is especially beneficial if tax rates rise in the future.
6) You earn a high income and would like to make Roth IRA contributions, but can’t based on the Roth IRA income limits
- Roth IRAs have income limits, but Roth Individual 401k plans have no income limits.
- Everyone qualifies for a Roth Individual 401k. In 2015 you can’t contribute fully to a Roth IRA if your adjusted gross income exceeds 181,000 if you file a joint tax return with your spouse and $116,000 if you file as single or head of household.
- Higher contribution limits are permitted with a Roth Individual 401k than a Roth IRA regardless of income.
- In 2015 participants can contribute up to $18,000 to a Roth 401k and $23,000 if age 50 or older. The 2015 Roth IRA contribution limits are $5,500 and $6,500 if age 50 or older.
7) You wish to reduce future taxes on social security benefits
Qualified withdrawals from a Roth Individual 401k are excluded from taxable income when calculating taxes on Social Security benefits.
Currently half of Social Security benefits are taxable if AGI (adjusted gross income) plus one half of social security benefits exceeds $32,000 if married filing jointly or $25,000 if single. Note that the $32,000 / $25,000 threshold has never been adjusted since 1993. As a result, the value of tax savings via Roth accounts increases over time. Distributions from a Traditional 401k are included in AGI for determining Social Security benefit taxes, but distributions from a Roth Individual 401k are excluded, therefore saving taxes on Social Security benefits. Consult your tax advisor to verify your tax savings.
8) You want to avoid taking Required Mandatory Distributions (RMDs) at 70 ½ and you like the idea of passing assets tax free to your heirs
You can roll over a Roth Individual 401k to a Roth IRA and avoid the legal requirement to take withdrawals at age 70½. This can save significant taxes and be useful for estate planning because the taxes saved will increase your estate and your heir's distributions will be tax free in the future as well.
However, remember the following important considerations:
- Roth contributions are irrevocable. Once the money goes into a Roth 401k account, it can't be switched over to a regular 401k.
- Also, Roth contributions are subject to federal state and payroll taxes in the year the Roth contribution is made (but are withdrawn tax free at retirement and grow tax free during working years).
- You can roll over Roth Individual 401k contributions to a Roth IRA when retired or if terminated.
- There is never a requirement to take a distribution from any Roth type retirement plan. This can help with tax planning to minimize taxes on Social Security benefits.