It’s no secret that many firms today offer 401(k) retirement plans to their employees, but if your firm is offering a Roth option in its 401(k) plan, it may be worth considering for your retirement savings.
Like a Traditional 401(k), a Roth 401(k) is a retirement savings plan offered by employers to facilitate their employees saving for retirement. The key difference is that the Roth 401(k) is funded with post‐tax dollars, whereas contributions to a Traditional 401(k) are made prior to paying income tax. The funds in both accounts grow tax‐free, meaning no capital gains tax is owed on the growth of the investments, and the annual contribution limits are the same.
What is the difference between a Roth IRA and a Roth 401(k)?
The most significant difference between a Roth IRA and a Roth 401(k) is the annual contribution limit. Mirroring the Traditional IRA, a Roth IRA has a lower contribution limit: $6,000 per year for those under age 50 and $7,000 for those 50 and older. The annual contribution limits are notably higher for a Roth 401(k), just as they are with the Traditional 401(k): if you’re under age 50, you can contribute $19,000 and if you’re 50 or older, up to $25,000 is permitted. Another key difference is that the IRS limits those who can contribute to a Roth IRA based on income. Single filers with a Modified Adjusted Gross Income (MAGI) above $137,000 (or $203,000 for married couples filing jointly), are ineligible to contribute to a Roth IRA. The Roth 401(k) has no such income restrictions and, therefore, can provide a significant advantage to those saving for retirement.
What are the benefits of a Roth 401(k)?
In addition to the absence of income restrictions, the two major benefits to the Roth 401(k) are that withdrawals in retirement are tax‐free and there is no Required Minimum Distribution (RMD) beginning at age 70 1⁄2. Those with retirement savings in pre‐tax accounts may have large RMDs, which are taxed at regular income tax rates, potentially making their tax liability higher in retirement than when they were actively working.
It’s understandable then that people may be reluctant to spend their hard‐earned, pre‐tax retirement savings because a portion of their withdrawal goes directly to paying taxes. By saving in a Roth 401(k), you’re subsidizing your future life. Logic suggests that it makes sense to save in a Roth when you’re younger and in a lower tax bracket, but even if you’re at a higher earning level now, it might make sense to pay the taxes while you have a steady stream of income.
How is the Roth 401(k) treated at death?
A Roth 401(k) is treated the same as a Traditional 401(k) plan at death. If you’re married, your spouse must be the sole beneficiary unless he or she signs a waiver allowing you to designate someone else to receive the inheritance. Regardless, the beneficiary will be subject to Required Minimum Distributions, but when these RMDs must be taken is dependent on a variety of factors. This is one of the many reasons it is important to understand the policies your employer has set in place for its 401(k) plan. Some plans allow the beneficiary to roll the funds out into an Inherited IRA, but others require assets to remain in the plan until they’re exhausted.
Typically plans allow the beneficiary to complete their RMDs over the course of their own lifetime, not the decedents’, as determined by the IRS’ RMD life expectancy tables. This is advantageous for beneficiaries because it allows them to manage their tax exposure since distributions are treated as income. Be sure to update your beneficiaries along with major life changes, such as a divorce, in order to ensure that your heirs receive the funds you intended for them. Accounts without beneficiaries will end up in probate, where a court will ultimately decide who receives the assets.
How do I start contributing to a Roth 401(k)?
Many employers now offer the Roth 401(k) as part of their regular benefit package. Whether you are new to your company or have been there for a while, speak with the human resources department to find out about your options. Just like a traditional 401(k), all Roth 401(k) contributions must be made through payroll; your employer will withhold a set dollar amount or percentage of your paycheck every pay period to put into the plan.
Keep in mind that you can split your contributions between a Traditional 401(k) and a Roth 401(k) if you would like, allowing you to contribute both pre‐tax and post‐tax dollars. Very few private employers offer pensions anymore and we are therefore in charge of saving for our own retirement. Fortunately, a Roth 401(k) provides both tax deferred growth and the flexibility to manage your tax liability in retirement. As always, it’s best to talk to your financial advisor and CPA to make sure it’s the right option for you.