Definition:
The Roth 401(k) is an employer-sponsored retirement plan that allows after-tax contributions. It combines features of the Roth IRA and the traditional 401(k) to allow tax-free distributions in retirement.
How does the Roth 401(k) work?
Roth 401(k) plans – also known as designated Roth accounts – are available only through employers who choose to offer them. Any contributions you make to the Roth 401(k) are after-tax contributions, meaning you won’t receive a tax deduction in the year you contribute. In other words, you won’t receive an upfront tax benefit, which would lower your taxable income in your contributing years.
Like a 401(k) account, employers can choose to match any contributions you make through the plan. Unlike your contributions, employer matching contributions are made on a pre-tax basis into a separate account. As a result, when you withdraw from your Roth 401(k) in retirement, a portion will be tax-free.
Your own contributions will be subject to tax upon withdrawal. Employer matching contributions will be tax-free upon withdrawal.
There can be clear tax benefits to the Roth 401(k), but the biggest advantage is that once you retire, you can withdraw your money from the Roth 401(k) without paying taxes.
Example of the Roth 401(k)
Let’s say you decide to participate in the Roth 401(k) offered by your employer. You earn $60,000 and choose to contribute 6% of your salary to the Roth 401(k) each year.
Your employer offers a matching program of 50% on the first 6% you contribute. In other words, the employer will add 3% of your salary to your retirement account each year as long as you contribute 6%. The amount saved will grow over the years, depending on your investment choices, but you won’t pay any taxes on the returns.
In retirement, you can withdraw your contributions and the earnings on those contributions from the Roth 401(k) tax-free since you did not receive a tax break in your contribution years. However, distributions from the employer matching contributions will be subject to income tax at your current tax rate in retirement.
Roth 401(k) vs. Traditional 401(k)
The Roth 401(k) is similar to the traditional 401(k) in many ways, with one key difference – it deducts your contributions (not the employer’s contributions) after tax, meaning taxes have already been deducted from your income before you make contributions. As a result, you may not have to pay taxes on your distributions and income when you retire.
With a traditional 401(k), you make pre-tax contributions, meaning your taxable income is reduced by the contribution amounts, lowering your tax bill in the contribution year. However, your distributions are taxed in retirement.
When considering a traditional 401(k) or a Roth 401(k), it is helpful to estimate the tax bracket you will be in during retirement, as this bracket will affect the amount of taxes you may have to pay. If you expect to be in a higher tax bracket when you retire, the Roth 401(k) may be a better option since your distributions will be tax-free. However, if you estimate you will be in a lower tax bracket when you retire, contributing to the traditional 401(k) is the better choice.
How much
Should I Contribute to Retirement?
Some experts suggest allocating 10% to 15% of your pre-tax income for retirement, but you may need to work to reach that amount.
If you have an employer matching program, be sure to contribute enough to qualify for the match, as it’s free money added to your retirement savings. For example, if your employer offers a 5% match, they will contribute 5% of your salary as long as you also contribute 5%. In other words, the match helps you double your savings rate.
However, you must participate in a Roth 401(k) or a traditional 401(k) to qualify for the match. So be sure to contact your retirement plan administrator to find out if there is a matching program and how you can take advantage of it.
What Happens If I Change Jobs?
If you change jobs, you can transfer your 401(k) balance to another 401(k) or an IRA account. When doing this, you must transfer it to the same type of account. For example, if you have a Roth 401(k), you can transfer it to a Roth 401(k) or a Roth IRA; you cannot roll over distributions from a Roth 401(k) to a traditional 401(k) or an IRA.
You can convert a traditional 401(k) to a Roth 401(k) or IRA, but you will be expected to pay taxes at the time of conversion. If you don’t have the available cash, it’s better to roll it over to a traditional account instead.
These rollover rules can get complicated, so it’s advisable to talk to your accountant or financial planner to determine how a Roth 401(k) can benefit you and the proper way to execute any conversion. Your financial planner can also help you develop an overall investment strategy that will help you build wealth over time.
Frequently Asked Questions (FAQs)
What is the difference between a 401(k) and a Roth 401(k)? Contributions to a traditional 401(k) are made with pre-tax dollars. In other words, contributions are made before taxes are deducted from your paycheck, which lowers your taxable income in the year of contribution. However, 401(k) distributions are taxed in retirement.
In contrast, contributions to a Roth 401(k) are made with after-tax funds, meaning taxes have already been deducted from your pay, with no upfront tax benefit in the year of contribution. However, you have the potential not to pay taxes on withdrawals from the Roth 401(k) in retirement.
What is the difference between a Roth IRA and a Roth 401(k)? The Roth 401(k) is different from the Roth IRA. For example, the Roth IRA has an annual income limit, meaning you cannot contribute if your earnings exceed that limit, whereas there is no income limit for the Roth 401(k). Additionally, the Roth IRA has lower contribution limits than the Roth 401(k).
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