A Roth 401(k)???
You’ve heard of a 401(k) and you have heard of a Roth IRA, but a Roth 401(k) might be new to you. In the post, we’ll describe what this account is and why it is a great option for those looking to save and invest.
What is a Roth 401(k)?
A Roth 401(k) is an employer-sponsored retirement savings account that is funded with an investor’s after-tax dollars. The Roth 401(k) was introduced in 2006 and offers a hybrid option for saving and investing that combines features from the traditional 401(k) plan and a Roth IRA.
This new 401(k) plan has been catching on quickly, with more employers offering the Roth 401(k) as an option.
The key feature of the Roth 401(k) is that employee contributions are made with after-tax dollars. Tax is paid up front and contributions and earnings grow tax-free and can be withdrawn tax-free.
This feature makes the Roth 401(k) popular among younger investors, who anticipate they will be in a higher tax bracket later in life towards retirement. The Roth 401(k) allows them to pay taxes now while they are in a lower tax bracket.
While a Roth 401(k) and a Roth IRA both are funded with after-tax dollars, the annual contribution limit on the Roth 401(k) is much higher than the limit of the Roth IRA. This means you can invest more in your Roth 401(k).
The contribution limit for a Roth 401(k) in 2020 is $19,500 if you are younger than age 50. This is three times the contribution limit that a single filer is allowed to contribute to a Roth IRA ($6,000).
When it comes to employers matching contributions, there are no differences between a traditional 401(k) and a Roth 401(k).
If your employer matches your contribution up to 5%, they will match it up to 5% for either option you choose to enroll in. It is important to highlight that the amount the employer matches will be taxed.
Similarities Between a Roth 401(k) and a Traditional 401(k)
The Roth 401(k) and the traditional 401(k) share most of the same features.
Both are employer-sponsored saving/retirement account options. You can contribute to either one and have those contributions deducted from your paycheck.
Contributions are automatically deducted
Enrolling in a 401(k) plan and having your contributions automatically pulled out of your paycheck takes the effort out of saving and investing.
If you were given your full paycheck and told yourself that you would pull out hundreds of dollars a month to save and invest, it’s likely you would not follow through or would forget. The contribution method for the Roth 401(k) and traditional 401(k) make it convenient for the investor.
Eligibility for employer match
As mentioned earlier, both are eligible for an employer match if your employer offers a contribution match.
With an employer matching your contribution up to 5% of your salary, you are essentially receiving free money. Enrolling in the plan should be a no-brainer for anyone working for a company that offers a 401(k). However, only a small number of employees take advantage of this.
Subject to contribution limits
Finally, both 401(k) accounts have contribution limits and they have the same limit amounts. The amount for 2020 that an individual can contribute is $19,500.
It is important to point out that the contribution limits for a 401(k) are substantially higher than contribution limits for other accounts such as IRA’s or health savings accounts (HSA).
This gives an individual an option with more capacity to save, invest, and max out their contributions to a tax-advantaged account.
Both types of 401(k) accounts require the investor to begin taking distributions at age 72.
Differences Between a Roth 401(k) and a Traditional 401(k)
The major difference between the two 401(k) accounts is related to the taxation of funding and distributions/withdrawals from the accounts.
A traditional 401(k) account is funded with an employee’s pre-tax income. The larger pre-tax income amount is saved, invested, and grows through the life of the account.
When withdrawals are made, the funds comprised of contributions and investment earnings will be subject to taxation at that time.
A Roth 401(k), similar to a Roth IRA, is funded with an employee’s after-tax income. It is a post-tax retirement savings account. The after-tax contributions can grow tax-free and be withdrawn tax-free and penalty-free (within the rules).
The Roth 401(k) may feel like it’s hitting you harder financially in the current time, but the benefit on the back end is where the power of the Roth 401(k) comes in.
Once you pull money out from your Roth 401(k), you can do so with the peace of mind knowing you will not have a tax bill to pay on it.
Deductions from paycheck
As mentioned, the Roth 401(k) is funded with after-tax earnings and the traditional 401(k) is funded with pre-tax earnings.
On your paycheck though, this means that funds contributed to a traditional 401(k) will be pulled from your gross earnings amount before your paycheck is taxed.
With a Roth 401(k), the contributions are deducted from your paycheck after it has been taxed. The result of this is taking home a little less on your paycheck by choosing to enroll in a Roth 401(k) versus a traditional 401(k).
We have already established that withdrawals for one will be tax-free while withdrawals for the other will be taxed, but let’s discuss the rules with the withdrawals and distributions.
With a traditional 401(k), withdrawals of contributions and earnings are taxed and penalties will be charged on distributions that are taken before age 59 ½.
A Roth 401(k) has different rules. Withdrawals of contributions and earnings will not be taxed as long as the distribution is qualified.
The IRS considers a distribution qualified if it is made from an account that has been open for at least 5 years and the distribution is taken on or after age 59 ½ or for another special circumstance (e.g. disability or death).
So with both accounts, you can begin taking penalty-free withdrawals at and after age 59 ½, but withdrawals from the Roth 401(k) will require the account to be 5 years old.
Although the traditional 401(k) and Roth 401(k) are similar in having required distributions, the Roth 401(k) allows you to roll the balance into a Roth IRA without a tax burden.
Remember, the Roth IRA doesn’t require minimum distribution so funds can be preserved instead of distributed.
Advantages of a Roth 401(k)
The advantages of a 401(k), traditional or Roth, include the following:
- They are employee-sponsored accounts with the potential for an employer contribution match
- Contributions are automatically deducted from your paycheck, making it hassle-free to save and invest
- They both offer a variety of options to invest in for your retirement
Outside of these benefits, the advantages for the Roth 401(k) revolve around the tax benefits. It can be advantageous to pay taxes now on your contributions so your contributions and earnings can grow tax-free as well as be withdrawn tax-free.
In addition, paying taxes now is much less painful than paying taxes later. Paying taxes now on each contribution will be de minimis in comparison to the large tax bill that a traditional 401(k) withdrawal would come with.
Imagine taking a withdrawal during your retirement of $1 million and having to pay $300,000 in taxes! That would be gut-wrenching.
With a Roth 401(k), the contributions of after-tax money will feel painful at first, but you will soon get used to it and may even forget about it as everything is on auto-pilot.
Is a Roth 401(k) the Right Choice For You?
Deciding on whether the Roth 401(k) is right for you will depend on which tax benefits you want and what your current and future tax bracket status will be.
A Roth 401(k) is beneficial for those who are currently in a low tax bracket and expect to be in a higher tax bracket once they retire. Young people tend to fall into this group which is why the Roth 401(k) is popular among young investors.
If you are in a lower tax bracket now and expect to be in a higher one later, the Roth 401(k) would make sense because you would end up paying taxes now on your contributions at your current low tax rate and your withdrawals of contributions and earnings would be tax-free as you are in a higher tax bracket.
If you are in a lower tax bracket now and higher one later and went the traditional 401(k) route, you would get current tax benefits now with deductions of contributions against taxable income.
When you retired and withdrew your funds, you would pay tax on that entire amount at your tax rate status at the time of retirement, which is higher than before. This would not make sense.
A traditional 401(k) would be the better option when you are currently in a high tax bracket and expect to be in a lower tax bracket when you retire. You could reap the current benefits of taking deductions to your taxable income at your current high tax rate and pay taxes later on your withdrawals when your tax rate is much lower.
A traditional 401(k) may also be the better option for you if you don’t want to have to comply with the 5-year rule that a Roth 401(k) requires for a qualified distribution.
How to Contribute and Invest in a Roth 401(k)
Setting up your Roth 401(k) can be taken care of quickly.
As prerequisites, your employer must offer the Roth 401(k) as an option and you must be eligible to enroll in this benefit with your company. Some companies have a 90-day grace period that employees must pass before they can enroll in a benefit such as a 401(k).
Check with your payroll or human resources team to make sure you are eligible. It is also the payroll or human resources team that will set you up with the Roth 401(k) plan.
You will visit them and begin filling out the enrollment forms for the plan. You’ll select the Roth 401(k) option when you are given the option between that and the traditional.
Then, you’ll specify how much you want to contribute to the plan each month. More is better but don’t focus on contributing as much as possible if it is going to cause financial restraints and stress in other areas.
Once you fill out the paperwork and everything is processed, contributions to your Roth 401(k) account will be deducted from your paychecks automatically and your paychecks should state on the stub how much was allocated to your Roth 401(k).
If you wish to change your contribution amounts, you will have to contact the payroll or HR department that you opened the account with.
Investment 0ptions and strategy
When your Roth 401(k) is set up, you can select your investment options. You’ll have access to a variety of funds including stock funds, bond funds, blended funds, target-date funds, and money market funds.
Your 401(k) will be set up with using a dollar-cost averaging strategy, meaning that equal amounts of money will be invested on the same recurring time intervals.
Eligibility For a Roth 401(k)
To be eligible for a Roth 401(k), your employer has to offer one as an option.
A great thing about both 401(k) accounts is that they have no income limits to contribute. Income limits are one of the downsides to the Roth IRA, but with a Roth 401(k), you can contribute at any income level.
This is good news to you if you are a high earner or plan to be a high earner (which is all of us, right?!).
If your employer does not offer a Roth 401(k), you can opt for the Roth IRA, which shares benefits with the Roth 401(k), but still has major differences.
Despite the differences, as long as you are saving and investing for your future, you are doing the right thing. Choosing a Roth IRA is better than not doing anything because your employer doesn’t offer a Roth 401(k).
Since its introduction in 2006, the Roth 401(k) has been a popular option with investors. It offers many of the best benefits of both the traditional 401(k) and the Roth IRA.
If your employer offers the Roth 401(k) as an option, you should consider enrolling in it. Find out if the Roth or traditional route will be better for you.
One rule of thumb is to choose the Roth 401(k) if you are currently in a lower tax bracket than you expect to be in when you retire.
Enrolling in a 401(k) account sounds burdensome to most people, which may be why enrollment numbers are a lot lower than you would expect. However, enrolling in a Roth 401(k) plan just requires the filling out of a few pages of paperwork.
In exchange, you get access to the great benefits this savings/retirement account has to offer.