Unbeknownst to many investors, companies have the option of offering their employees a new different type of tax-advantaged retirement plan: the Roth 401k. Not all sponsors of Traditional, Pre-Tax 401ks have adopted the Roth feature, but it is not too early to consider whether contributing after-tax dollars to a Roth 401k can help you achieve greater financial security in retirement.
As the name suggests, the Roth 401k incorporates elements of both traditional 401k plans and the Roth IRA. Created by a provision of the Economic Growth and Tax Relief Reconciliation Act of 2001, the Roth 401k allows employees to make Roth IRA-type contributions to 401k plans, but without the income restrictions and contribution limits that apply to Roth IRAs. Contributions to a Roth 401k are non-deductible; however, earnings within the account accumulate tax-free, and qualifying distributions are also tax-free.
Pre-Tax 401k vs. After-Tax 401k
The Roth 401k is subject to the same contribution limits as the traditional 401k. In 2023, investors under the age of 50 are permitted to contribute up to $22,500 to a 401k, but only $6,500 to an IRA. Over 50 years old, you’re permitted to contribute up to $30,000 to a 401k, and $7,500 to an IRA.
The Traditional 401k requires investors to begin taking withdrawals after the age of 73. That distribution age changes, depending on the year you were born. If you’re still working at age 73, you don’t have to take RMDs from the account of the employer for which you currently work.
On the other hand, the Roth 401k resembles the Roth IRA in that investors will not be permitted to withdraw their money tax-free until they are at least 59 1⁄2 years old and have held the account for at least five years.
Is a Roth 401k Right for You?
Among those most likely to take advantage of the Roth 401(k) are higher earners who expect to be in the same or a higher tax bracket when they retire. These investors gain little in the long run by taking a tax break today, and they are more likely than moderate earners to be able to afford after-tax contributions. For these savers, accepting the “pain” of contributing to their 401(k) plan without the immediate tax deduction means they can enjoy tax-free distributions and greater flexibility during retirement.
But higher earners are not the only investors who could benefit from contributing to a Roth 401k. A report by the Vanguard Center for Retirement Research on the impact of the Roth 401k on retirement plans observed that the “tax diversification” offered by the Roth feature would help a wide variety of 401k plan participants better prepare for retirement.
Observing that plan participants cannot anticipate how changes to the tax code might affect their tax rate after retirement, the report’s authors recommend diversifying the tax risk associated with pre-tax saving by also contributing after-tax dollars to a Roth account.
The participants most likely to benefit from this tax diversification strategy are those who already have substantial retirement savings, those saving at the maximum limit on deferrals, those ineligible to contribute to the Roth IRA due to their high incomes, and those in the lower tax brackets who wish to lock in a low marginal rate. This last group includes younger employees who are likely to see their earnings increase significantly as their careers progress, such as physicians and lawyers.
The employees least likely to benefit from contributing to a Roth 401k are those who are not well-prepared for retirement and those with high temporary incomes.
Examine and Compare
Before deciding to divert all, or a portion of, your retirement plan contributions into a Roth 401k plan, you should take into account the restrictions and potential disadvantages associated with this option.
The stipulation that the Roth 401k be held for at least five years, and until the age of 59 1⁄2, before tax-free withdrawals are permitted could make this option less attractive if you are currently approaching retirement.
Unlike Roth IRA investors, Roth 401k contributors are not permitted to withdraw funds tax and penalty-free to pay for a first home or qualified educational expenses.
Also, take into account the impact of moving from pre-tax to after-tax contributions on your overall tax liability. Unlike 401k contributions, funds invested in a Roth 401k do not reduce your current taxable income. This shift could cause you to lose out on certain deductions you enjoyed while making contributions to a traditional 401k.
Check Your Employer Match to See Tax Requirements
You should also be aware that matching contributions made by employers may be invested in a traditional, not Roth-type, 401k account. This means that even if you make all of your contributions exclusively to a Roth 401k account, you would still owe tax in retirement on withdrawals from funds contributed on a pre-tax basis by their employers.
Which is Better for You? Roth 401k or Traditional 401k?
If, after reviewing your individual situation, you conclude that contributing to a Roth 401(k) makes sense for you, ask your company’s benefits administrator if the feature is being added to your existing retirement plan. If it is not already in place, expressing interest in the Roth feature increases the likelihood your company will adopt the option.
When it comes to retirement, planning for the future is crucial.
Here at West Advisory Group, we understand that retirement years are not linear – far from it. These years have many curves and knots along the way, all of which can conceal a big tax bill at the end of them.
Without the right strategy and guidance, these big bills can leave families scrambling when they don’t have to.
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We’re happy to talk you through your concerns, answer any questions, and give you peace of mind when it comes to what might be ahead on your retirement journey. give our office a call and our team is happy to set up some time to go over your options.