The Roth 401(k) is like a special savings plan for your retirement that’s offered by your employer. What makes it different from a regular 401(k) is how you put money into it. With a regular 401(k), you use money from your paycheck before taxes are taken out. But with a Roth 401(k), you use money that’s already had taxes taken out of it. This tax difference is important because it affects how much money you have to pay in taxes when you retire.
Taxes can eat into your retirement income, which can be tough on your budget. You might be surprised to find out that when you retire, you might have to pay taxes on a lot of your income sources, even on your Social Security benefits. And sometimes, the amount you owe in taxes can be more than you expected.
That’s why it’s a good idea to learn more about the Roth 401(k). If your employer offers this retirement plan, it’s helpful to understand how it can help you save on taxes during retirement.
Let’s take a closer look at the Roth 401(k) to see how it’s similar to a regular 401(k), whether you can contribute to both types at the same time, and what advantages the Roth 401(k) can offer you.
What is a Roth 401(k) and how does it work?
The Roth 401(k) is like a special part of your regular 401(k), and it’s sometimes called a “designated Roth account.” Think of it as a separate container for your money within your retirement savings.
When you put money into this designated Roth account, you don’t get a tax deduction for it. But here’s the cool part: when you take out the money during your retirement, you won’t have to pay any taxes on it. Plus, you won’t have to worry about paying taxes on the money your investments earn each year. In simple terms, you take care of the taxes up front by putting in money that’s already had taxes taken out of it.
This tax setup is the same as what you’d find in a Roth IRA, which is a personal retirement account not linked to your job. However, the Roth IRA has limits on how much you can put in each year and rules about who can contribute, depending on their income. The Roth 401(k), on the other hand, doesn’t have income restrictions, which is great if you earn a high income, maybe even in the six figures.
Roth 401(k) vs. traditional 401(k)
Let’s dive into how the Roth 401(k) works compared to the traditional 401(k).
With a Roth 401(k), the money you put in doesn’t give you a tax break right away. But when you take it out during retirement, you won’t pay any taxes on it. On the flip side, a traditional 401(k) lets you deduct your contributions from your taxes today, but when you withdraw the money in retirement, you’ll owe taxes on it as if it’s regular income.
On paper, the Roth approach, where you pay taxes upfront, makes the most sense if you think your tax rate will be higher when you retire. This way, you’re paying a smaller tax bill today instead of a potentially larger one later.
However, in reality, predicting your future tax rate is tricky. There are lots of factors at play, some of which you can’t control, like national debt and government policies.
Because of this uncertainty, having money in both Roth and traditional 401(k)s can be a smart move. It gives you flexibility in retirement, allowing you to choose between taxable and tax-free withdrawals to manage your tax situation as it evolves.
Can I contribute to both?
You have the option to save money in both a Roth 401(k) and a traditional 401(k) at the same time. If your retirement plan allows for Roth contributions, you can decide how much you want to put into each account separately.
But there’s a rule from the IRS you should be aware of. They set limits on how much you can put into your 401(k) each year. These limits cover the total amount you contribute to both your Roth and traditional 401(k) accounts combined. For instance, in 2023, if you’re under 50 years old, you can put up to $22,500 into your 401(k) for the entire year (this is an increase from $20,500 in 2022). So, if you decide to put $5,000 into your Roth 401(k), you’ll still have $17,500 left that you can contribute to your traditional 401(k) in 2023.
Let’s break down some important things about your Roth 401(k):
Employer Matching Contributions: These are deposits that your employer puts into your retirement account, depending on how much you save. If your 401(k) has a matching program, you can expect to receive these matching contributions for any eligible Roth contributions you make. It’s important to note that because matching contributions are made before taxes, they will be directed into your regular 401(k) account, not the Roth portion.
Withdrawals: When you’re 59 1/2 years old and you’ve had your Roth 401(k) for at least five years, you can take out money without paying penalties or taxes on Roth 401(k) withdrawals. There are exceptions, like if you become disabled. But here’s the catch: you can’t just take out your Roth 401(k) contributions whenever you want like you can with a Roth IRA. If you do, the IRS will calculate how much of it is taxable and slap a 10% early withdrawal penalty on it. So, let’s say 80% of your account is your contributions and 20% is earnings, you’d pay taxes and a penalty on that 20% if you take it out early.
In a traditional 401(k), there’s no such difference between contributions and earnings for tax purposes. Unless you meet an exception, you’ll owe taxes and penalties on any early withdrawals.
Required Minimum Distributions (RMDs): Both Roth and regular 401(k)s have something called RMDs. These are like mandatory withdrawals the IRS makes you take after you turn 72. The tricky thing is, RMDs can mess with your tax benefits because they make you move your money into an account where you can’t defer taxes on your earnings. Plus, they limit how much you can leave to your loved ones when you’re gone.
But here’s the good news: you can dodge RMDs by shifting your Roth 401(k) balance into a Roth IRA. You can also move your traditional 401(k) money into a Roth IRA, but be ready to pay taxes because you’re moving pre-tax contributions into an after-tax account.
Benefits of a Roth 401(k)
To sum it up, here are six great things about the Roth 401(k):
- Tax-Free Withdrawals in Retirement: When you reach 59 1/2 and your Roth 401(k) has been funded for at least five years, you can take out your money without worrying about paying taxes on it.
- Tax-Free Investment Growth: As long as you leave your earnings in the account until the right time, any money you make from investments, like gains, interest, or dividends, is completely tax-free.
- Generous Contribution Limits: The amount you can save in a 401(k) is much higher than what you can put into an IRA. These limits apply to the total you contribute across both Roth and traditional 401(k)s. You can choose to use all of it for your Roth or split it between your Roth and a regular 401(k).
- No Income Restrictions: There are no restrictions on how much you can contribute to your Roth 401(k) based on your income. You can put in up to the limit, no matter how much you make.
- Smart Way to Avoid RMDs: The IRS usually makes you take out a certain amount of money from your Roth 401(k) when you reach a certain age. But there’s a trick to dodge this. You can move your Roth 401(k) balance into a Roth IRA, and that way, you won’t have to worry about those required minimum distributions (RMDs).
Roth 401(k) for tax diversity and estate planning
The Roth 401(k) is a valuable tool for your retirement strategy. It allows you to enjoy tax-free withdrawals in retirement and offers high contribution limits without any income restrictions. Having both a Roth 401(k) and a traditional 401(k) gives you the freedom to choose between taxable or tax-free withdrawals when you retire.
Even better, if you find that you don’t need the money in your Roth 401(k) for your day-to-day expenses, you can transfer it into a Roth IRA. This way, you can leave it as an inheritance for your loved ones, providing them with a financial benefit.
