What Is a Roth Deferral?
A Roth deferral is money that a person puts in a Roth investment account to save for later in life, usually retirement. There are two types of Roth accounts: a standard Roth Individual Retirement Account, or IRA, and a Roth 401(k). Payments to either account must be made with post-tax dollars. The deferral is in the enjoyment: when participants withdraw, they do so tax-free.
All Roth accounts are facets of United States tax law and typically are only available in the U.S. or to U.S. citizens working abroad. The distinguishing feature of the Roth is that it is wholly funded with after-tax money. Workers receive their paycheck, pay the necessary income taxes, then choose to allocate some of the remainder to a qualifying account. This usually results in a deferral of that money for a later time, the specifics of which are usually set out by the plan.
There are several key differences between Roth IRA and 401(k) plans, but a Roth deferral happens under either one. The main idea behind a deferral is to save money in a growth account that can be used later in life without incurring a tax penalty. Money is usually invested in stocks, bonds, and mutual funds while in the account. Over time, the hope is that that money will grow in size and return on the initial principal. That growth is not usually taxed, which is why the accounts are so beneficial.
Investors are usually limited in terms of how much money they can defer and grow through a traditional Roth IRA. There are also usually income limits, such that people making over a certain annual salary are not eligible to participate. Money invested in this sort of Roth deferral account cannot usually be accessed before the investor has reached retirement age, either, though in most cases,it need not ever be distributed. Deferring money into this sort of account is often a means of transferring wealth and assets from one generation to the next. Once the account is eligible to be disbursed, the financial deferral can pass to anyone for use at any time.
The same is not usually true when it comes to Roth 401(k) accounts. This sort of Roth deferral is typically offered by and administrated by corporations for the benefit of qualifying employees. Deferral payments are usually made through direct paycheck deduction, and almost anyone is eligible to participate, regardless of how much money they make. There are still usually caps limiting annual deferral to a certain amount, but in most cases more can be contributed to a 401(k) deferral account than to an IRA in a given year.
Choosing the best Roth deferral is usually a matter of circumstance and careful financial analysis. Roth 401(k) plans can often hold more money, which makes higher returns more likely. The choices of investment vehicle are usually limited by the sponsoring corporation, however. Distribution is usually mandatory once the investor reaches a certain age, as well. It is sometimes possible to roll over a 401(k)-style plan into one that does not have a mandatory vest date, but not always.
What is the Difference Between Employee Deferral and Roth Deferral?
Both employee deferrals and Roth deferrals are employer-sponsored 401(k) plans that allow employees to assign a portion of their paychecks to a retirement fund. Although these plans have more similarities than differences, the points where they diverge are critically important.
Taxes and 401(k)s
There is a misconception that traditional 401(k) plans are tax-exempt whereas Roth plans are not. Both types of deferrals are subject to taxation. The key difference between the two is when those taxes are collected.
Funds contributed to a Roth 401(k) are taxed before they are allocated to the retirement fund. Since the funds are taxed at the front end when they are made, employees do not need to pay any taxes on the original contribution or the earnings from them when they are paid out after the age of 59 1/2.
Funds contributed to a traditional 401(k) are made with pre-tax dollars and will not be taxed until they are withdrawn from the account at retirement. Distributions from a traditional deferral plan are essentially treated as income in retirement and are subject to taxation at the employee's current tax rate.
When an employee moves from one job to the next, it is usually wise for them to take their 401(k) funds with them. Rolling over a traditional 401(k) plan from a previous employer to a new one is usually a simple process. Traditional plans can be rolled over to another traditional plan, to a Roth deferral if one is offered or to any qualified IRA.
Conversely, a Roth 401(k) can only be rolled over to another Roth 401(k) account or a Roth IRA. If the new employer does not offer a Roth deferral, the employee's options become limited. He or she can choose to maintain an account with the old employer or transfer from an employer-sponsored plan to a Roth IRA, thereby losing the benefit of employer-matched contributions into that account.
Retirement accounts exist to provide financial security when individuals age out of the workforce and are most in need of income; therefore, withdrawing the funds before that should not be done lightly. Both traditional and Roth deferrals allow for early withdrawals, but the employee will be charged a 10% tax penalty on top of any taxes owed for doing so. Because taxes have already been paid on a Roth account, the 10% penalty will apply only to taxable earnings such as funds derived from untaxed employer contributions.
Is a Roth Deferral the Same as a Roth IRA?
No, a Roth deferral is an employer-sponsored 401k, whereas a Roth IRA is a retirement account held by an individual.
Pros and Cons of a Roth IRA
An individual retirement account offers some freedoms not available to 401(k) account holders:
- A significantly larger pool of investment options
- No required minimum distributions, giving the account holder the ability to pass on a large sum of tax-free funds after his or her death
- Penalty-free withdrawals of original contributions at any time
Although the benefits are considerable, there are significant disadvantages as well:
- No employer-matched funds
- Low income and contribution limits
- Loans cannot be taken from the account
Is Roth Deferral or Pre-Tax Deferral Better?
There is no simple answer to this question. It depends on the investor's unique financial situation.
For individuals whose income remains steady into retirement, there may be no significant financial difference between the two types of plans. They will either pay taxes in the present or a similar amount of taxes in the future. These individuals may want to consider other factors such as whether they anticipate multiple job changes and the need to roll over retirement plans in the future.
For those who expect to be in a lower tax bracket in retirement, a traditional 401(k) plan will allow them to grow their investments while deferring tax payments until they are in a lower tax bracket. Depending on the size of the account, this could be a difference of thousands of dollars of income.
Conversely, those who believe that their income will grow steadily over the years and hope to retire with significant income from investments or other sources may benefit from a Roth deferral. In this way, they pay taxes while they are in a lower tax bracket and then use their retirement savings as tax-free income while they are in a higher bracket. Additionally, since disbursements from a Roth account are not considered taxable income, having this type of retirement account could reduce social security and medicare premiums as well.
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