Before 2006, individuals saving for retirement could use a traditional 401(k) plan or any number of savings accounts that were not specifically designed for that purpose. However, since 2006, savers have had another option: the Roth 401(k) plan. A Roth 401(k) plan is a retirement savings plan that allows you to contribute after-tax money to a specific account within a 401(k) plan, which is dedicated solely to Roth contributions.
Benefits of Roth 401(k) Plans vs. Traditional 401(k) Plans
The easiest way to understand how 401(k) plans work is to compare them to traditional 401(k) plans.
Tax Savings
Roth 401(k) plans provide the opportunity to contribute after-tax money, meaning contributions are made after tax deductions from your paycheck. In contrast, contributions to traditional 401(k) plans reduce taxable income and total tax liability in the year the contribution is made, making it easier to bear.
Tax-Free Withdrawals
Most often, you can withdraw money from a Roth 401(k) in retirement without paying income tax on the money. However, to do so, you must follow IRS rules, including waiting until you reach age 59 and a half and keeping your account open for at least five years. On the other hand, withdrawals from your 401(k) account, including contributions as well as any earnings, are taxed based on your income tax rate in retirement since you received a tax deduction upfront when contributions were made.
Employee and Employer Contributions
There are two types of contributions to a 401(k) account: employee contributions and employer contributions.
Employee Contributions
When you direct a portion of your salary into a 401(k) account, you are engaging in a “salary deferral” (also known as employee contributions). You can choose whether you want to make traditional or Roth contributions or both, up to the annual aggregate limit.
Employer Contributions
Your employer may also choose to add money to the plan and help you build your retirement savings. These contributions are known as employer contributions and come in two types. An employer might match your contributions and add the same amount to your 401(k) account in each paycheck, up to a certain limit.
Contribution Limits for Roth 401(k) Plans
You can only contribute a specified amount to a Roth 401(k) plan, and the limits are the same as for contributions to a traditional 401(k) plan.
In-Plan Transfers
If you have money in a pre-tax savings fund, you may be able to convert it to Roth funds in your 401(k) plan. This is called an in-plan transfer. You must pay taxes on the pre-tax amount to do so.
Deciding to Work with a Roth 401(k) Plan
A Roth 401(k) plan offers another savings option, but this type of account may or may not be suitable for you. Talk to a qualified tax advisor before making your decision.
Roth 401(k) vs. Roth IRA Account
Aggressive savers might want an additional savings method to help grow their nests quickly, while those who do not need to save a lot might prefer an alternative. A Roth IRA account is one of those options, and you will have an easier time with a Roth IRA account if you understand how Roth 401(k) accounts work, as they have many similarities.
Contribution Limits
There are annual upper limits on contributions to a Roth 401(k) account. The maximum annual contribution limit for an IRA is $6,000 in 2022 ($6,500 in 2023) or $7,000 for individuals over age 50 in 2022 ($7,500 in 2023). By contributing to both a Roth IRA and a 401(k) account, you can maximize tax-advantaged savings.
Limits
Income
Your income must be below certain thresholds to use a Roth IRA. You can only make Roth IRA contributions if you earn less than $144,000 as a single filer in 2022 ($153,000 in 2023) and $214,000 if you are married and filing jointly in 2022 ($228,000 in 2023). However, these income levels do not prevent you from making Roth 401(k) contributions.
Withdrawals and Distributions
Most of the time, you can withdraw money from a Roth IRA (but not withdrawals that include earnings on that money) at any time without paying taxes or penalties. Check with your personal accountant before doing so. Any withdrawals may require you to take a proportional share of pre-tax and after-tax money if you have both traditional and Roth funds in your 401(k). This could lead to income tax and penalties if you withdraw money early.
Frequently Asked Questions
How does a Roth 401(k) contribution work? Contributions to Roth 401(k) plans are made with after-tax dollars, which means the contribution is made after tax is deducted from your paycheck. There is no upfront tax deduction with Roth 401(k) contributions – it does not reduce the taxable income in the year of contribution.
How much can I contribute to my Roth 401(k)?
The contribution limits for Roth 401(k) plans are the same as for traditional 401(k) plans. The maximum annual contribution is $20,500 in 2022 ($22,500 in 2023). You can make additional contributions of $6,500 in 2022 ($7,500 in 2023) if you are age 50 or older.
Source: https://www.thebalancemoney.com/overview-of-roth-401k-315498
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