Roth 401(k): How to Tell If a Roth 401(k) Is Right for You?

Planning for retirement might seem like a complex process because of the sheer number of retirement accounts. Wider choice is good but it can also be intimidating, essentially because you want to be sure that your choice of retirement accounts is ideal as per your financial goals. Recently, a novel retirement account, known as a Roth 401(k) account, has been gaining popularity. The account has a few common features of the traditional 401(k) with a host of other advantages. Typically, a Roth 401(k) account couples the tax benefits of a Roth IRA (Individual Retirement Account) with the traditional 401(k) account to offer a wise retirement investment option. However, the suitability of this new retirement investment vehicle needs to be evaluated individually.

To understand if a Roth 401(k) is right for you, you must first understand the account, its implications, differences, and benefits.

What is a Roth 401(k) account?

A Roth 401(k) is a retirement investment savings account sponsored by the employer. This account includes after-tax contributions up to a specified limit and provides tax-free distributions in retirement. However, there are no limitations in terms of income for participation in a Roth 401(k).

A Roth 401(k) contrasts a traditional 401(k), which includes pre-tax contributions. These pre-tax contributions are later taxed upon future withdrawals. A Roth 401(k) acts as a hybrid retirement savings tool that hosts the best features of a traditional 401(k) and Roth IRA. This tax-advantaged savings vehicle is best suited for people that estimate themselves to be on a higher tax bracket in retirement.

What are the contribution and withdrawal limits for a Roth 401(k) account?

For 2020, you can contribute up to $19,500 in your Roth 401(k) account, if you are below 50 years. If you are above 50 years, the account permits additional contributions up to $6,500.

In terms of withdrawals, no withdrawals from a Roth 401(k) account attract taxes, if they are a qualified distribution. Roth 401(k) plans have two qualification criteria. Firstly, you must hold the account for a minimum of five years. Secondly, the account holder or owner should be at least 59.5 years old at the time of withdrawal. In case the owner and withdrawer are two different people, both should be 59.5 years old.

Alternatively, in case of permanent disability or if the withdrawals are from an inherited Roth 401(k) account, the distributions are considered as qualified. In case of an early withdrawal, the IRS (Internal Revenue Service) applies a 10% penalty on the taxable part of the non-qualified distributions. The early withdrawal penalty is exempt in specific cases, such as permanent disability, beneficiary withdrawals, etc.

What differentiates a Roth 401(k) from a traditional 401(k) account?

Both Roth 401(k) and traditional 401(k) have equal contribution limits. But these accounts widely differ in terms of taxes on the contributions and distributions. That said, you can invest in both these popular retirement savings tools, provided you adhere with their contribution limitations.

The main points of difference between a Roth 401(k) and a traditional 401(k) account are:

Taxes on contributions: In a traditional 401(k) account, the contributions you make are pre-tax, which ultimately minimize the current adjusted gross income. However, for a Roth 401(k), all contributions you make are adjusted for adequate taxes. This does not create any impact on your present adjusted gross income.

Taxes on withdrawals: In case of a traditional 401(k) account, distributions in retirement are considered as ordinary income and hence, are taxed accordingly. However, for Roth 401(k) the IRS does not imply any taxes on the distributions if they are qualified.

Withdrawal rules: For both retirement savings accounts, withdrawals made before the age of 59.5 years attract a 10% penalty unless you meet any of the specified exceptions. However, in a traditional 401(k), the withdrawals of contributions and earnings are charged with taxes. While for a Roth 401(k), withdrawals of contributions and earnings are not charged any fee, if the distribution is qualified by the IRS. For qualified distributions, the account must have been actively held for a minimum of five years, or the withdrawals must be made on or after the age of 59.5 years. In case of disability of the owner of the Roth 401(k) account, the distributions are considered as qualified and no taxes are levied.

How to know if a Roth 401(k) is good for you?

A Roth 401(k) is best suited for you if you are likely to be in a higher tax bracket in retirement. However, the decision of retirement savings account is majorly dependent on how the funds are contributed and how they are withdrawn.

For example, if you are in a smaller tax-bracket presently and prefer to pay off taxes now to evade the higher tax burden in retirement, then you would be more suited for a Roth 401(k) account. In a Roth 401(k), the contributions you make in the present will be deducted for adequate taxes. This will help you protect yourself from higher tax liability in the future, assuming you fall in a higher tax bracket in retirement. Even though your overall income in retirement may fall, given the possible increase in the tax rate of the future, you could be subjected to an upper tax bracket.

So, suppose you contribute $10,000 today after taxes in your Roth 401(k) account. You can be sure that you will withdraw $10,000 whenever needed; unlike a traditional 401(k), where the $10,000 will be adjusted for taxes, as per the future tax bracket.

A Roth 401(k) reduces your current paycheck since your contributions to the account are tax-adjusted. This helps you to be certain of your tax liabilities and make financial plans and adjustments accordingly for a secure retirement. Leaving your tax liabilities for the future is not the ideal strategy for a safe retirement.

If you are not inclined to reinvest your tax savings, then considering a Roth 401(k) would be good. This is because to equalize your after-tax earnings of a traditional 401(k) with a Roth 401(k) account in the future, you would need to reinvest your tax savings each year. In case you fail to reinvest, the tax savings of the present could affect your funds of the future because of higher tax liabilities.

A Roth 401(k) account is ideal for you if you surpass the income eligibility levels of a Roth IRA. With Roth 401(k) you can get tax-free investment growth even if you earn a significantly higher income otherwise.

Money in a Roth 401(k) account can be converted into a Roth IRA with minimum complications. This will help you avoid the obligations of minimum retirement distributions.

A Roth 401(k) account also helps to improve liquidity. You can borrow up to 50% of the balance or $50,000 (whichever is lower) from a Roth 401(k) account. However, if you fail to comply with the loan terms, the distributions will be taxable.

To sum it up

Overall, investing in a Roth 401(k) account offers you several advantages. But the suitability of the Roth 401(k) account depends on your financial condition and overall retirement objective. Generally, it is advisable to make optimum use of all possible retirement accounts to diversify taxes and save more for retirement.

For help, you can seek expert guidance from a professional Financial Advisor and be sure that you are making the right retirement decisions.