Is your company offering you the option to open a Roth 401(k) but don’t know how the plan will benefit you? The Roth 401(k) plan is a hybrid between a pre-tax 401(k) and a Roth IRA that comes with unique tax benefits. If you are new to retirement savings, I have put together the pros and cons of a Roth 401(k) plan to help you make the right choice.
What is a Roth 401(k) plan
The Roth 401(k) plan is an employer-sponsored plan where you make contributions with after-tax money. Similarly to the pre-tax 401(k) plan, contributions to the Roth 401(k) plan come from your paycheck through payroll deductions. The plan allows you to grow your account potentially tax-free and qualified distributions will be tax-free, according to the Internal Revenue Service(IRS).
Here are the pros and cons of the Roth 401(k) plan you should know before you open the plan.
Pros of Roth 401(k) plan
The Roth 401(k) plan comes with unique tax benefits that make it stand out among other retirement plans.
Here are the pros of the Roth 401(k) and what you should expect by opening a Roth 401(k).
There are no income limits to participate in a Roth 401(k) plan
Unlike the Roth IRA where eligibility is based on modified adjusted gross income(MAGI) and filing status; the Roth 401(k) does not have income limits. As long as you are eligible to contribute to the plan through your employer, you can participate in the plan.
Your employer may match your contributions
One of the greatest benefits of Roth 401(k) is that you might get an employer match to help boost your retirement savings. The portion from your employer, however, will be treated as before-tax money. For this reason, this amount will be saved in a different account and you will pay income tax on this amount during retirement and associated earnings.
Your contribution and earnings from Roth 401(k) can be withdrawn tax-free. However, you could pay tax on earnings from your contributions when you make a withdrawal from an account that this not at least 5 years old. A 10% penalty could also apply if you withdraw the money before you turn 59½.
You might also like: What does it mean to be vested in my 401(k)?
Roth 401(k) comes with higher contribution limits than IRA limits
One of the greatest benefits of a Roth 401(k) over a Roth IRA is that you can contribute a large amount compared to a Roth IRA. Large contribution limits mean you can easily boost your retirement savings which also gives you greater tax benefits.
The Roth 401(k) contribution limits in 2024 are $23,000 or $30,500 if you are 50 or older. These contribution limits are much higher than the Roth IRA contribution limits where you can contribute up to $7,000 or $8,000 if you are 50 or older.
For 2023, the contribution limits to Roth 401(k) are $22,500 or $30,000 if you are 50 or older while the limits for an IRA are $6,500 or $7,500 if you are 50 or older.
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You will grow your account potentially tax-free
Since contributions to your Roth 401(k) are already taxed, you will grow your account potentially tax-free.
If the employer matches your contributions, however, the money will be considered before-tax money. As a result, any growth from these contributions will grow on a tax-deferred basis. Tax-deferred growth means that you delay paying taxes until you are taking distributions. When you retire, you will pay taxes on any withdrawals that can be considered part of gross income.
You will pay no taxes on qualified distributions
Unlike pre-tax 401(k) where you pay income tax on your withdrawals, qualified distributions to your Roth 401(k) will not be taxed.
So, what is a qualified distribution from a Roth 401(k)?
To make a qualified distribution, you must be at least 59½ and the account must be at least 5 years since you made your first contribution. Individuals who became disabled or who take money out of the account after the owner dies are also exempt from tax liability.
You can avoid RMDs by rolling over your Roth 401(k) to a Roth IRA
The great benefit of retirement savings is tax benefits. For example, the IRS will let you stash away a portion of your before-tax wages, grow your account, and pay tax only when you are getting your distributions. This allows you to focus on growing your account instead of worrying about taxes.
To recoup those unpaid taxes on your contributions; the IRS requires that you start taking money out of your retirement account when you reach a certain age. In addition, there will be a minimum amount you must take out every year. These distributions are known as required minimum distributions(RMDs).
When you turn 73, you must start taking RMDs out of your Roth 401(k) account. Failure to take RMDs may result in a 50% penalty on the money you did not take out on time.
One of the greatest benefits of Roth 401(k) is that you can avoid RMDs by rolling over your funds into a Roth IRA.
Note: Even if you take RMDs from your Roth 401(k), you will not pay tax on contributions you made to the account. This is because your contributions were taxed right from the beginning.
Cons of 401(k) plan
While the Roth 401(k) plan comes with a lot of benefits, the plan also comes with disadvantages. Here are the cons of Roth 401(k) you should know.
No upfront tax benefits
Many people don’t like Roth 401(k) because it does not offer upfront tax benefits. Every dollar you contribute to a Roth 401(k) comes from after-tax wages.
This makes it difficult to make large contributions to the account as contributing more can greatly lower your take home. If your employer matches your contributions, however, that portion will be considered after-tax money. As a result, you will pay tax on the portion of your distribution that came from your employer and associated earnings.
RMDs are required when you turn 73
Another disadvantage of the Roth 401(k) plan is RMD requirements when you turn 73. Although you will not pay taxes on your contributions to the plan, employer contributions to your account and associated growth will be taxed.
The extra tax on your distributions can increase your retirement overall tax liability especially when you are still working or earning an income.
Employer match and associated earnings are taxed during retirement
While you make contributions to your 401(k) plan with after-tax wages, your employer match to the plan will be before tax. For this reason, you will pay tax on these contributions and related earnings during retirement.
You may pay a 10% penalty if you withdraw money early
Most retirement accounts require that you turn 59½ before taking distributions. Taking distributions earlier than this age violates IRS withdrawal rules.
The Roth 401(k) also follows the same withdrawal rule. You must be at least 59½ to take distributions from your Roth 401(k) without a 10% penalty unless you meet exceptions set by the IRS.
There is a 5-year waiting period before you can take contributions tax-free regardless of age
Unqualified withdrawals from your Roth 401(k) plan may also result in a tax liability. The money you contributed will not be taxed since you pay taxes already. However, returns on your contributions, employer contributions, and associated earnings may be taxed if your distributions are not qualified. In other words, any portion of your distribution that can be considered a gross income will be taxed.
To avoid taxes on your earnings, you must have the account for at least 5 years.
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