Would you like to pay taxes on your savings after you retire? If the answer is no, then the Roth 401(k) and the Roth IRA are ideal for you. However, even within these options, you must choose which plan you want to contribute to. Our guide is designed to give you an overview of these accounts, their rules, limitations, and advantages so that you may make a more informed decision.
The basics of a Roth 401(k)
The Roth 401(k) is one of the many retirement savings options available out there. Like a regular 401(k), it has to be provided to you by an employer, so you cannot contribute to such a plan independently. The key advantage of a Roth 401(k) is that while you have to pay taxes on any contributions you make, you pay no taxes once you retire and start making withdrawals at the age of 59½.
The Roth 401 (k) account has been a part of retirement account options since 2006 via the passage of the Pension Protection Act (PPA) of 2006. Not all employers offer a Roth 401(k) yet, but the account type is still increasing in popularity. While the Roth 401(k) was originally intended to be a temporary type of account, it became permanent via passage of the PPA.
When are withdrawals from a Roth 401(k) not penalized?
To encourage saving more responsibly, the government does not permit withdrawals from any type of 401(k) accounts lightly, which is why there are significant rules you need to observe. The Roth 401(k) allows you to make penalty-free distributions provided that you fulfill a few requirements.
Firstly, you must be above the age of 59½, and secondly, you must have had the account for a minimum of 5 years. If you make a withdrawal without fulfilling these requirements, you may have to pay a 10% tax penalty, which can affect your savings significantly.
What are the advantages of a Roth 401(k)?
The key advantage of a Roth 401(k) is that you will pay no taxes on it for all withdrawals taken past the statutory age of 59½ years. You might wonder: What difference does it make I pay taxes now rather than paying them later?
Well, it can definitely make a difference. If you expect to have progressed to a higher bracket of tax when you are older or when you reach retirement, you will have to pay greater tax on your withdrawals at the older age.
Generally speaking, most people will end up in higher tax brackets as a result of having higher earned income. For these people, the tax savings one can accrue by contributing to a Roth 401(k) compared to a Traditional 401(k) can be rather significant.
The Roth 401(k) has a significant advantage for the government as well, and this is because Roth 401(k)s generate immediate revenue since they are taxed today. Moreover, as an investor, you need to understand how useful a Roth 401(k) could be. Just think about it; your contributions to the account will be taxed today, so once the money is in it, it can grow freely, and you do not have to pay taxes no matter how much it grows.
Should I go for a Roth 401(k) or a Traditional 401(k)?
This decision is based on your personal preferences and everyday expenses. At the outset, it is important to know that you may not have any choice in the first place to choose a Roth 401(k) as many employers do not offer it.
However, the Roth 401(k) is excellent long-term since the withdrawals and income earned are tax-free. No matter how big your withdrawal after retirement or how much you have earned on it, you do not have to pay taxes. With a traditional 401(k), you save taxes now, but your withdrawals on retirement are taxed.
Now it may seem that a Traditional 401(k) has no benefit compared to a Roth 401(k), but that’s not necessarily true. The immediate contribution you make to a Roth 401(k) is not taxed, reducing the income you have to pay tax on. Remember, the primary “selling point” of a Traditional 401(k) is its benefit of saving taxes today. This can help many people who have more immediate cash needs, such as for rent, food, or student loan payments, via the tax deductions afforded by Traditional 401(k) plans.
Side by Side comparison or Roth 401(k) and Roth IRA
So far, we have been comparing Roth 401(k) accounts to Traditional 401(k) accounts. We now turn our attention to another comparison: that of Roth 401(k) versus Roth IRA. (As you may recall, a Roth IRA is an account that one owns outside of an employer and is funded with after-tax money.)
Here are the primary differences:
- A Roth IRA has maximum income requirements in order to eligible to contribute; a Roth 401(k) has no income limits.
- If one meets the income requirements, anyone can contribute to a Roth IRA, but only those whose employers offer a Roth 401(k) may contribute to the latter.
- In any given tax year, one can contribute significantly more to a Roth 401(k) compared to a Roth IRA (for Tax Year 2021, the amounts are $19,500 and $6,000 respectively for individuals under 50 years of age).
Can I contribute to more than one plan?
Yes, you can contribute to more than one retirement plan at one time as well. This usually works out if you have two things: an employer who offers the Roth 401(k) plan in the first place and earned income that you can contribute to the Roth IRA. This can help you maximize your savings and gain the tax benefits of a Roth account at retirement.
Given the differences specified in the previous section, however, it is far more likely that an individual can contribute to both a Traditional 401(k) and a Traditional IRA rather than to both a Roth 401(k) and a Roth IRA.
In short, both Roth 401(k) and Roth IRAs have redeeming qualities which make them suitable for retirement savings vehicles. Although they share the same first name, the two types of retirement accounts have only one similarity: They enable withdrawals during retirement to be made tax-free. In all other respects, they are very different, and one must consider his or her individual circumstances to determine which type of account is best for him or her.
In the end, having both Roth 401(k) and Roth IRA accounts can be reasonable, as is having neither of the two. Please feel free to reach out to us to discuss which types of retirement vehicles are best suited for your particular needs and goals.