Roth 401(k)

A Roth 401(k) is among the two primary categories of 401(k) plans, and it provides considerable tax advantages to employees who save for retirement. The regular 401(k) is another major plan, and it offers substantial but different tax advantages for retirement savings.

Here's everything you need to understand about Roth 401(k)s so you can decide if they're good for you.

What’s a Roth 401(k)?

A Roth 401(k) is a kind of employer-sponsored retirement savings plan which allows employees to contribute after taxes have been deducted. When that employee retires, he or she will be able to take tax-free withdrawals.

In 2006, the Roth 401(k) was introduced, combining characteristics from both the standard 401(k) and the Roth IRA. Like a traditional 401(k), you can use a Roth account to take the benefits of an employer match on the contributions, if your employer offers one. Furthermore, the Roth feature of a Roth 401(k) allows you to make tax-free withdrawals.

The income tax is paid directly on the money that the employee has taken from every paycheck and deposited into the retirement account. Withdrawals from the retirement fund would be tax free after the employee retires.

How does it work?

The person’s age determines contribution limits for a Roth 401(k). Individual contribution limits in 2020 and 2021 are $19,500 annually. Individuals aged 50 and up are eligible for a catch-up payment of $6,500.

If your employer matches your contributions, you may contribute to a Roth 401(k). A Roth 401(k) deposits matched funds into a tax-deferred account.

The Roth 401(k) account should be held for a minimum of 5 years. The account holder should only make withdrawals due to a disability, if the account owner reaches the age of 59½, or after the account holder’s death.

Unless the employee is still working at the company holding the 401(k) and is not a 5% (or more) owner of the company sponsoring the plan, distributions are needed for employees who are at least 72 years old (70½ before January 1, 2020).

Upon retirement, you can make tax-free withdrawals from a Roth 401(k) for covering your living expenses, paying off debts, and emergency expenses. Non-qualified withdrawals from a Roth 401(k) are pro-rated based on your contributions and income. Additionally, you may be charged the 10% early withdrawal penalty on funds classified as gross income.

To avoid a penalty, you must begin collecting required minimum distributions (RMDs) after you reach the age of 72 (70½ before January 1 or earlier). When you retire, you can avoid this obligation by rolling your Roth 401(k) into a Roth IRA, which does not require RMDs. This way, your funds can keep growing tax free, and your heirs won’t have to pay taxes on distributions if you pass your IRA over to them.

Employer-sponsored Roth 401(k) plans are the only way to invest in a Roth 401(k). If your company only offers a regular 401(k) with matching contributions, you’ll be wasting money if you don’t participate. 

What are the benefits of a Roth 401(k)?

Employees in a low tax bracket but intend to shift into a higher tax bracket upon retirement may benefit the most from a Roth 401(k). Contributions will be taxed at a reduced rate currently, while retirement withdrawals will be tax free.

The tax-free distribution is the most significant benefit. The money in the fund will be tax free throughout retirement, regardless of how much it grows over time.

There is a minor disadvantage with this retirement plan. Since contributions to a traditional 401(k) are not taxed right away, they have a lower impact on your take-home pay and maximize your tax break for the year.

How are they different from traditional 401(k)s?

When considering future advantages, a Roth 401(k) may be a superior option. You need to pay income tax on your contributions in current-dollar to build a tax-free retirement nest egg. Significantly, both the contributions and the income will be tax free over time. A regular 401(k) account, on the other hand, requires you to pay income tax on the total amount you withdraw.

However, the Roth 401(k) takes a bigger bite out of your existing annual income.

If you’re nearing retirement, the immediate tax savings may be more appealing than the chance of future tax-free withdrawals. If you plan to be in a lower tax bracket after retirement, the typical tax advantage of a 401(k) may be more beneficial.

When would someone want to choose a Roth 401(k) over other options?

The advantages of a Roth 401k above other options cannot be overlooked. The most appealing factors for selecting this option are the financial benefits of reduced tax deductions and tax-free withdrawals.

However, you can’t overlook the emotional agony that investing in alternative options can create. Imagine reaching retirement age and discovering that your $2 million nest egg has been reduced to less than $1,600,000 after the tax deduction! You’ll miss $400,000 in retirement far more than you’ll miss $250 in a paycheck right now. You’d rather pay taxes now than watch all that profit disappear later.

You probably wouldn’t care about the amount you’re saving in taxes if you start the habit of putting 15% of every paycheck into your Roth 401(k). You’ll be delighted to notice that you don’t owe the government a single penny from your hard-earned savings when you retire.

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