Retirement planning can be tricky to undertake due to the availability of several types of retirement accounts. To make the right choice, you need to first assess the pros and cons of each retirement plan and how it would prove helpful when it comes to achieving your financial goals. In this article, we will be focusing on the Roth 401(k) account, a tax-advantaged account that combines the tax benefits of a Roth IRA (Individual Retirement Account) with the traditional 401(k) account. To understand and evaluate the said account, its tax implications, benefits, and more, it would be wise to consult with a professional financial advisor who can guide you on the same.
What is a Roth 401(k) account?
A Roth 401(k) is an employer-sponsored retirement saving account wherein you contribute after-tax dollars to be able to make tax-free withdrawals in retirement. However, in a Roth 401(k), there are no restrictions placed on you in terms of income to contribute to the account.
A Roth 401(k) differs from a traditional 401(k), wherein an investor contributes pre-tax dollars that are later taxed at the time of making withdrawals in retirement. It is a hybrid investment vehicle that combines the best features of traditional 401(k) and Roth IRA accounts. A Roth 401(k) is most suited for those investors that expect to be in a higher tax bracket in retirement.
What are the new contribution limits for a Roth 401(k) account for 2022?
The Internal Revenue Service (IRS) has increased the contribution limit for a Roth 401(k) to $20,500 in 2022 from $19,500 in 2021. If you are 50 years of age or older, you can contribute an additional catch-up contribution of $6,500 bringing your total to $27,000.
Are there any conditions that need to be met to make tax-free withdrawals from a Roth 401(k)?
Similar to a Roth IRA account, if you wish to make tax-free withdrawals in retirement, the following conditions need to be met:
- The account must be held by the investor for a period of at least 5 years.
- The owner must be 59.5 years of age or older at the time of withdrawal.
However, you can make early withdrawals but you would need to pay a 10% penalty on the taxable part of the non-qualified distributions. In certain cases, the early withdrawal penalty is exempt such as permanent disability, beneficiary withdrawals, etc.
How is a Roth 401(k) account different from a traditional 401(k) account?
Though both traditional and Roth 401(k) accounts have equal contribution limits, they vary greatly when it comes to taxation on contributions and distributions. You can invest in both these retirement accounts given that you adhere to the contribution limits. The major points of difference between these two accounts are as follows:
Taxes on contributions:
In a traditional 401(k) account, you make pre-tax contributions meaning any sum that you contribute or earnings generated by you are tax-deferred. On the other hand, in a Roth 401(k), contributions by employees are not tax-deferred but are made with after-tax dollars. However, any income earned from investments such as interest, dividends, or capital gains, is tax-free.
Taxes on withdrawals:
In the case of a traditional 401(k) account, distributions received at the time of your retirement are treated as ordinary income and thus, taxed accordingly. This is not the case for a Roth 401(k). No taxes are levied on distributions provided they are qualified.
Withdrawal rules:
If you make a withdrawal before reaching the age of 59.5 years, both retirement accounts i.e. traditional 401(k) and Roth 401(k) attract a 10% penalty. However, there are some exceptions to this rule. In the case of a traditional 401(k), you have to pay taxes on any earnings generated and contributions withdrawn by you. Whereas for a Roth 401(k), withdrawals of contributions and earnings are not taxed provided you make a qualified distribution. For qualified distributions, you must be 59.5 years of age and hold the account for a period of at least 5 years. If the Roth 401(k) account owner suffers from a disability, the distributions are considered as qualified and no taxes are levied.
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Is Roth 401(k) a good fit for you?
If you believe you would be in a higher tax bracket in retirement, then a Roth 401(k) may be a good choice for you. Let us understand this with the help of an example. Say, you are in a lower tax bracket at the present and prefer to pay taxes now to avoid paying taxes on withdrawals in retirement. You make after-tax contributions in a Roth 401(k) in the present, thus, protecting yourself from higher tax liability in the future, assuming you fall in a higher tax bracket in retirement. Moreover, by doing so, you can ensure that you receive your full contributions without having to pay a higher tax rate in the future. For instance, suppose you contribute $5,000 today after taxes in your Roth 401(k) account, you can rest assured that you would be able to withdraw $5,000 whenever needed if you make a qualified withdrawal. That is not the case with a traditional 401(k), where the $10,000 will be adjusted for taxes, as per the future tax bracket.
Investing in a Roth 401(k) helps prepare for a safer retirement as your contributions are tax-adjusted and have taken care of your tax liabilities. Moreover, you can make your financial plans and adjustments accordingly taking into account your reduced paycheck. Further, a Roth 401(k) would be ideal for you if you do not wish to reinvest your tax savings {that you will make if you invested in a traditional 401(k)}. An added benefit of investing in a Roth 401(k) is that you can receive tax-free investment growth even if you surpass the income eligibility levels of a Roth IRA. Additionally, you can easily convert your Roth 401(k) account into a Roth IRA account to avoid paying RMDs.
Lastly, you can improve your financial liquidity with a Roth 401(k). You can borrow against your Roth 401(k) account balance - up to 50% of the balance or $50,000 (whichever is lower). But you would be liable to pay taxes on the distributions if you are unable to comply with the loan obligations.
To conclude
A Roth 401(k) account offers several benefits to an investor. However, whether you should invest in the account or not depends on your financial condition and overall financial goals and needs. It would be wise to consider all retirement accounts before choosing one that best fits your financial situation and future objectives. Whether you wish to reinvest your tax savings, pay tax now to take advantage of tax-free withdrawals in retirement, or want to have a wider choice and flexibility when it comes to investment instruments; consulting with a professional may be the right call to make an informed decision.
If you wish to understand more about a Roth 401(k) and how it could fit in your retirement strategy, use the free advisor match service to connect with an advisor who can help you on the same. Answer a few questions about yourself and the match service will help connect you with 1-3 financial advisors that are best suited to meet your financial requirements.