Roth 401(k) plans are a relatively new retirement savings option that may have been brought to your attention if you’ve recently reviewed your firm’s benefits package.
The number of programs that provide a Roth 401(k) option has exploded in the past five years alone. You’re in luck because over 75 percent of corporate retirement plans now include a Roth option.
Predictably, this new alternative is attracting younger individuals who are eager to make the most of the tax benefits it provides. Actually, today’s members of Generation Z are the most likely (14%) to contribute to a traditional 401(k) plan at work.
One of the two primary 401(k) plans is the Roth 401(k). It provides substantial tax benefits to employees who are saving for retirement. As an employer-sponsored plan, the Roth 401(k) can only be used if your employer provides it. The typical 401(k), which is the other significant plan, provides substantial but varied tax advantages for retirement investments.
Find out if the Roth 401(k) is the best option for your retirement funds by reading the information provided below.
What Exactly Is a Roth 401(k)?
Employer-sponsored retirement plans like the Roth 401(k) allow you to save money without paying taxes now and later. The money you put into the account is typically through payroll deductions.
These funds are invested in various pools of capital, such as stocks, bonds, and other securities. If you choose to put your money into a Roth 401(k), it will grow tax-free and enjoy other perks throughout that time.
A hybrid of the traditional 401(k) as well as the Roth IRA, the Roth 401(k) was first made available to Americans in 2006. Similar to a traditional 401(k), a Roth 401(k) allows you to receive a company match on your contributions (k). Furthermore, the Roth portion of a Roth 401(k) allows you to withdraw your money without paying taxes.
The main advantage of the Roth 401(k) and the reason why experts recommend it is that you can access your retirement savings tax-free after you reach age fifty-nine and a half. A Roth 401(k) is a type of retirement plan in which employees contribute after-tax dollars rather than pre-tax dollars; as a result, they do not receive an immediate tax benefit from the plan.
How Does a Roth 401(k) Work?
The 401(k) is a common retirement plan provided by companies. It’s a way for workers to save for retirement without having to pay taxes now but instead when they withdraw their money later in life.
To avoid paying taxes on investment growth or withdrawals in retirement, taxpayers can put pretax income into a Roth IRA or a Roth 401(k). Your taxable income will be reduced by the amount contributed to a traditional 401(k), but contributions to a Roth 401(k) are not tax deductible.
A Roth 401(k) account can be opened by anyone, regardless of income level, except for a traditional Roth IRA, if their company offers such a plan.
In contrast to Roth 401(k) accounts, Roth IRAs do not have RMDs, or minimum withdrawal requirements until you reach age 72. Thus, Roth 401(k) account holders (whether still employed or a 5% owner in the plan sponsoring company) is required to begin withdrawing funds from their accounts as early as age 72.
What Are Roth 401(k) Contribution Limits?
A Roth 401(k) is subject to the same contribution limits as a traditional 401(k). The 401(k) contribution limit for 2022 is $20,500 per employee.
Each successive limit increases the preceding one. If you already have more than one 401(k) account, your total yearly contributions to all of them cannot exceed the restrictions.
For example, if you have a Roth and a traditional 401(k) or even a 401(k) account involving two employers because you switched jobs, you can’t put more than $20,500 into all of your 401(k)s at once.
Those who are 50 or older and getting close to retirement can add an extra $6,500 to their annual contribution limit of $27,000 by making “catch-up” contributions.
Employees who will turn 50 by the end of 2023 are eligible to make catch-up contributions worth $7,500 in addition to the $22,500 contribution limit.
What are the Roth 401(k) Withdrawal Rules?
When cashing out a Roth 401(k), you have two primary options. Both qualified and nonqualified distributions are available for withdrawal.
- Qualified Distributions. If you get a qualified distribution, the IRS won’t penalize you for it. Your retirement accounts should be used for these and only for these purposes.
To withdraw money tax-free from your Roth 401(k), you must follow two simple guidelines. Your account must be at least 5 years old and you must be 59 and a half or older to withdraw funds.
In the event of a prolonged disability or death, however, early eligible distributions are permitted. Finally, if you pass away, your 401(k) will be distributed to your designated beneficiaries.
Hardship withdrawals are not a good idea, even if they are allowed by some plans. If you are not facing bankruptcy or foreclosure, you should never withdraw from or cash out your Roth 401(k). If you run into any other trouble, use the money in your emergency fund.
- Nonqualified Distributions. Don’t take money out of your Roth 401(k) before you absolutely have to if you don’t fulfill the criteria for qualified distributions. As such, it would be an early withdrawal or nonqualified distribution.
Even if withdrawals of contributions are exempt from taxation, any money you make after that is considered gross income and subject to income tax. The IRS also assesses a 10% early withdrawal tax penalty, which must be paid.
It’s not worth the hassle. Furthermore, there goes any chance of that money appreciating in value in the future as well.
Roth 401(k) vs. Traditional 401(k): What’s the Difference?
Whether or not your contributions to a Roth 401(k) are taxed at the time of contribution is the primary distinction between a Roth and a traditional 401(k). Since taxes are already so perplexing, let’s start with a basic explanation before delving into the particulars.
The money you put into a Roth 401(k) is already taxed, so you won’t have to worry about paying taxes on it this year. Your funds might accumulate within the account without triggering any tax consequences. The primary advantage is the ability to withdraw your entire retirement fund, including your contributions and any returns, tax-free once you reach retirement age.
Since contributions to a traditional 401(k) are made before taxes are deducted, you’ll save money on your tax bill this year. The money in the account can continue to grow without having to be taxed each year. Eventually, in retirement, you’ll want to cash out some or all of your savings, and doing so will result in taxable income.
Roth 401(k): Pros and Cons
Roth 401(k) loans, like any other kind of loan, come with their share of benefits and drawbacks. A detailed discussion of them will follow below.
Those who are in a lower tax rate now but anticipate being in a higher one when they retire may benefit the most from a Roth 401(k). For tax purposes, contributions to a Roth 401(k) are treated the same as those to a traditional 401(k).
The biggest perk is definitely the lack of taxation on withdrawals once you reach retirement age. Withdrawals from a retirement account are not subject to federal income tax, regardless of how much money has accumulated in it over the years.
The disadvantage is that you will feel the financial pinch more quickly. As opposed to Roth 401(k) contributions, which are taxed as soon as they are distributed, traditional 401(k) contributions are not subject to income tax in the year they are made, reducing the effect on your take-home earnings while maximizing your tax benefit.
As opposed to a traditional 401(k), a Roth 401(k) does not have this provision. What this implies is that you will have to pay taxes on the money you put into the account in the same year that you put it there, even though you won’t be able to deduct the money from your income.
Can You Make Contributions to Both a Roth and a Traditional 401(k)?
Each year, you can make contributions to both a traditional 401(k) and a Roth 401(k), but your account can only be in one of these formats at any given time. Don’t forget that the yearly cap applies regardless of how your contributions are broken up.
You can set your account such that contributions are either Roth or traditional, allowing you to make Roth contributions in the first half of the year and traditional contributions in the second. In many cases, you can make changes to your plan on your own time by contacting the plan’s administrator or by going online.
The 401(k) administrator keeps track of how much was deposited into each account and when, so facilitating the generation of necessary tax documentation upon retirement.
Those who anticipate a higher income later in life may benefit from establishing a Roth 401(k). It provides wonderful advantages for employees who are saving for retirement, not the least of which is the possibility of making tax-free withdrawals in the future.
While employees won’t have to pay taxes on their employer’s matching contributions till around retirement, those who would rather pay taxes on their personal contributions now may find a Roth 401(k) to be a handy option.
It’s also a good option for those with higher incomes, who can’t normally take the opportunity of the Roth IRA’s tax benefits unless they go through a “backdoor Roth.”