A Roth 401(k) is a retirement savings account that combines features of a traditional 401(k) and a Roth IRA. It offers individuals the opportunity to save for retirement while enjoying tax benefits. If you’re considering opening a Roth 401(k), here are the top 15 things you need to know.
1. Contributions: Like a traditional 401(k), contributions to a Roth 401(k) are made with after-tax dollars, meaning you don’t get an immediate tax deduction for your contributions.
2. Tax-free growth: One significant advantage of a Roth 401(k) is that your investments grow tax-free over time. This means that when it comes time to withdraw funds during retirement, both your contributions and investment earnings can be taken out without owing any federal income taxes.
3. Contribution limits: The contribution limits for a Roth 401(k) in 2021 are $19,500 for individuals under age 50 and $26,000 for those aged 50 and above (including catch-up contributions). These limits may change each year due to inflation adjustments.
4. No income restrictions: Unlike a Roth IRA, which has income limitations on who can contribute, anyone can contribute to a Roth 401(k), regardless of their income level.
5. Employer matching: Many employers offer matching contributions as part of their employee benefits package. While these employer matches are not taxed, they will be deposited into the traditional portion of your account rather than the Roth portion.
6. Rollovers: If you leave your job or retire, you have the option to roll over your Roth 401(k) into another qualified retirement plan or an individual retirement account (IRA). This allows you to continue benefiting from tax-free growth until it’s time for withdrawals.
7. Required Minimum Distributions (RMDs): Unlike traditional IRAs and traditional 401(k)s, which require minimum distributions once you reach age 72, Roth 401(k)s have no RMDs during your lifetime. This feature makes them an attractive option for estate planning and passing on wealth to future generations.
8. Early withdrawals: While it’s generally best to leave your retirement savings untouched until retirement, life happens, and sometimes you may need to withdraw funds early. With a Roth 401(k), you can withdraw your contributions penalty-free at any time since taxes were already paid on that money.
9. Taxation of earnings: If you withdraw investment earnings before age 59½, they will be subject to both income tax and a 10% early withdrawal penalty unless you qualify for an exception such as disability or a first-time home purchase.
10. Flexibility in retirement: During retirement, having both Roth and traditional accounts provides flexibility when it comes to managing your taxable income. By strategically withdrawing from each account type, you can potentially lower your overall tax burden.
11. Diversification of tax risk: Saving in a Roth 401(k) allows individuals to diversify their tax risk by spreading their retirement savings across different types of accounts with varying tax treatments (Roth vs traditional). This approach helps manage the uncertainty of future changes in the tax code.
12. Tax diversification for heirs: Inherited Roth IRAs are subject to specific distribution rules but generally offer beneficiaries the ability to receive distributions over their lifetime without owing federal income taxes on qualified withdrawals. By designating a beneficiary for your Roth 401(k), you provide them with potential long-term tax benefits as well.
13. Backdoor conversions: High-income earners who exceed the eligibility limits for direct contributions to a Roth IRA often utilize backdoor conversions by contributing after-tax dollars into a traditional IRA and then converting those funds into a Roth IRA shortly thereafter. However, if you have access to a Roth 401(k), this workaround is unnecessary since there are no income restrictions associated with it.
14. Tax-free withdrawals for qualified expenses: Roth 401(k) accounts may allow penalty-free withdrawals before age 59½ for certain qualifying events, such as paying for higher education or a first-time home purchase. However, taxes will still apply to any investment earnings withdrawn.
15. Estate planning benefits: Roth assets are not included in your taxable estate, which can be beneficial when considering estate planning strategies and minimizing potential estate taxes.
In conclusion, a Roth 401(k) offers many advantages for retirement savings. It allows tax-free growth, has no income restrictions on contributions, and provides flexibility during retirement. By understanding the key features and benefits of a Roth 401(k), you can make informed decisions about your retirement savings strategy and potentially optimize your financial future.