Many companies now offer employer-sponsored Roth 401(k) retirement accounts alongside traditional 401(k) plans.
What is the difference between the two accounts?
When should you consider opening a Roth 401(k)?
In a traditional 401(k), employees contribute pre-tax dollars from their salary and allocate it to a variety of investment options of their choice. Contributions and earnings grow tax-deferred until they are withdrawn, usually in retirement.
The main difference in a Roth 401(k) is when your contributions are taxed. You make Roth 401(k) contributions with after-tax dollars meaning money that has already been taxed. Your earnings then grow tax-free and you pay no taxes at the time of withdrawal.
Withdrawal Age & RMDs
Another difference between the two depends on the time or age of withdrawal. If you withdraw money from a traditional 401(k) plan before you turn 59.5, you pay taxes and potentially a 10 percent penalty.
With a Roth 401(k), you can withdraw your contributions (cost basis) tax-and penalty-free. The only caveat is that if the distribution is not a “qualified distribution,” the earnings will be taxable and also potentially subject to the 10 percent penalty.
Both Roth 401(k)s and traditional 401(k)s require minimum distributions (RMDs) once you reach age 72 (70.5 if you turned this age before 2019). This holds unless the individual is still employed at the company that holds the 401(k) and is not a 5% (or more) owner of the business sponsoring the plan.
Another key advantage of a Roth 401(k)s is that you can avoid RMDs when you retire by rolling your Roth 401(k) into a Roth IRA. A Roth IRA has no RMDs so your assets can continue to grow tax-free and they can be passed along to your heirs. This provides significant flexibility.
With a Roth 401(k), you can also still get matching contributions from your employer as you would a traditional 401(k). Both, have the same annual contribution limits. This does not mean however that you can contribute the limit into both of your accounts. The limit applies across both accounts. For example, you would not be able to contribute $19,500 to both types of 401(k)s in 2021. You would have to divide that amount between the two accounts.
A Roth 401(k) does have a higher contribution limit than that available for a Roth IRA.
Decision time: When does a Roth 401(k) can make sense?
Taxes are a key consideration when it comes to deciding on a Roth 401(k).
If you are
- Early in your career and presumably in the lower tax bracket now than you will be when you retire, a Roth 401(k) could be a better option than a traditional 401(k). You can take advantage of the low tax rate now, and then enjoy tax-free earnings later in life.
- Mid-career and also concerned about the possibility of entering a higher tax bracket later in life, a Roth 401(k) could be a better option. Especially in 2021 with tax rates being fairly low by historical standards, paying taxes now may make sense. That said, if you think you may be in a lower tax bracket come retirement age, Roth 401(k) might not be best.
- High tax bracket earners who expect to stay in the same bracket come retirement age and expect the same level of income into retirement, a Roth 401(k) could be a better option than a traditional 401(k). You can simply pay taxes up front while you are still working, limiting the need of having to take RMDs later on, which are seen as taxable income.
Covering your bases through tax diversification
If your company offers both traditional 401(k) and Roth 401(k) accounts, one option is to contribute to both a Roth 401(k) and a traditional 401(k). The combination will give you taxable and tax-free withdrawal options, and will allow you to choose which account to tap into based on your current tax bracket standings when the time comes. You could take RMDs from your traditional 401(k) account and withdraw the additional amount you may need for living expenses from the Roth 401(k) and do so tax free. By reducing your taxable income in retirement, you could also lower the amount you pay in Medicare premiums and the tax rate on your Social Security benefits while maximizing the availability of other income-based deductions.
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