Why Would I Want a Roth 401k?
A Roth 401K’s biggest feature is that it’s funded with after-tax dollars. That means when funds are withdrawn, they are not taxed. The account has to be open for at least 5 years and the owner at least 59.5 years old to make withdrawals. It’s a favorite of people who expect to be in a higher tax bracket in retirement. They can pull out the money without paying any taxes.
A growing number of employers offer the Roth 401k as an option in their benefit package. The limit on contributions in 2021 is $19,500. People over 50 can increase that $6,500. If your employer offers both a traditional 401k and a Roth – you can contribute to both accounts.
Is a Roth 401k the same as a Roth IRA?
The primary similarity is that they are funded by after-tax dollars.
A Roth IRA is a personal account, not an employee benefit. There’s no option for an employee match. The IRA accepts your direct contributions and from your spouse. You can rollover money from another account or transfer funds.
There is no contribution schedule, you can add money at will. The annual contribution limit is $6,000 or $7,000 if you’re over 50. Roth IRAs can’t be purchased if your income is too high. In 2021, a single filer making more than $140,000 is ineligible. Married couples filing jointly hit the limit at $208,00.
Withdrawals can be made tax free, at any age, if they only include the amount of your contributions. To withdraw any earnings from the account, there is a 5-year rule and age qualification.
The Roth 401k is a retirement option that is offered by many employers. In addition to direct contribution, the account can accept matching funds from an employer. You can transfer funds from other accounts to your Roth 401k, but there are some rules around the transfer. There can be tax benefits by transferring pre-tax dollars from a traditional 401k. Consult your CPA or financial adviser for current tax liabilities.
The annual contribution limit is much higher than an IRA. In 2021, the annual limit is $19,500 and $26,500 for people over 50. You can have a traditional 401k and Roth 401k, but the annual limit must be split between the two accounts. There are no income restrictions for starting an account.
Tax-free withdrawals are more restricted than the IRA. The account must be open for 5 years and the owner 6 months away from their 60th birthday. Withdrawals can also be made in the event of a disability or death of the account holder. Withdrawals that don’t meet that criteria can be taxed and penalized.
Is a Roth 401k Better than a Traditional 401k?
Neither should be considered “better.” Both have advantages, but much depends on your financial outlook. The table below highlights the similarities and differences between the two types of accounts. If you want to control when you can take retirement, either one is better than none.
Let’s look at how each account will play out in real life.
Assumptions: In 2020 you made $85,000 a year. Assuming you took the standard deduction of $12,400, your taxable income is $72,450.00. Your tax bracket is 22%. You owe federal income taxes of $11,688. If you’re paid twice per month, your gross monthly salary is $7,083. Taxes are withheld at $974 per paycheck or $1,948 a month.
The recommended contribution to your traditional 401k is 10% of your gross pay. As per the example above, $8,500 reduces your gross income to $76,500 and your taxable income to $63,950. Your tax bracket is now 12%. The amount of tax withheld per paycheck is $378 or $818 per month. That is a significant drop from the original numbers in the example.
If we make the same 10% contribution to the Roth 401k, there is no deduction. The contribution is taxed as income. Nothing from the assumptions have changed.
Assumptions: The account holder is 40 when starting the account. After 25 years, estimating a 7%, return, both 401ks will be worth $725,125. (That total does not factor in salary increases, contributions over 10%, or employer matching funds.)
With a traditional 401k, you can take withdrawals once you are 59 1/2 years old. Any money you take from the $725,125 is taxed as income. You need a new roof on the house and want to put in a pool and plan to withdraw $60,000 to do it. That’s 60k in taxable income. If you’re still earning the $85,000 in salary, your gross income is now $145,000. The tax bracket is still 22%. Your federal tax liability is $25,809. Adding on that 60k cost you $14,121 in taxes.
- If your salary increased to $110,000 over the years, the 60k brings your income to $170,000. Your tax bracket rises to 24%. After the standard deduction, the total federal tax liability is $31,809. Without that 60k, the tax owed after a standard deduction is $17,409 at 22%. That withdrawal costs you $14,400 in taxes. That makes your 60,000 worth 45,600.
- If you’re not drawing a salary, the 60,000 falls in the 12% tax bracket. It will cost you $6,188 after the standard deduction, so you get 53,812.
A withdrawal from the $725,125 in a Roth 401 is tax-free. As long as you’re over 59 1/2. When you withdraw $60,000, you get 60,000. There’s no tax or no penalty. If your salary (and your tax bracket increased) no problem. You could yank out $250,000 if you wanted. No tax.
This is what appeals to high earners and investors. They expect their tax rate to be higher by the time they reach retirement age. As you advance through your career, chances are good your income potential rises. Investment income and short-term capital gains come into play.
Choosing Your Best Option
Either way, nothing you do now is written in stone. The best choice is to put as much in a 401k as you can.
Some companies only offer traditional 401ks. Most employers offer a match for your contributions. The amount you need to put in to get it will vary. So will the amount of the match. If you can meet the contribution threshold, the employer match is free money.
If you have the option for a Roth 401k, do the same to get the employer match. Remember the money your company puts in taxable. The long-term perspective – a Roth 401k gives you more fluidity in retirement. But it comes at the cost of a smaller paycheck now. If you can let yourself get used to that lesser monthly amount, your retirement fund is tax-free.
Required Minimum Distribution (RMD)
An RMD is the amount the IRS says must be distributed (withdrawn) from retirement accounts. This includes your 401ks, traditional IRAs, and SEP OR SIMPLE retirement accounts.
The distribution must be complete on April 1st, following the account holder’s 72 birthday. If you miss it, you pay a hefty excise tax. An RMD calculation uses the end-of-year balance in your account. Multiply that amount by a life expectancy rate from the IRS. The Uniform Lifetime Tables were updated in 2019 to reflect a longer life expectancy. This reduces the amount of each RMD so people can hold onto their retirement income longer.
Any withdrawal from a Roth 401k is tax-free. But if you miss a deadline for making an RMD, the penalty imposed by the IRS is extreme. If you don’t make your withdrawals or you don’t take out enough, you will pay a 50% excise tax on the missing withdrawals.
There’s a workaround for a Roth 401k if you’re worried about missing a deadline. Transfer your balance to a Roth IRA, which is not subject to RMDs.
A Roth Solo 401K Plan
If you’re self-employed, you can set up a Roth Solo 401k plan. It’s an excellent alternative to a SEP retirement plan for sole practitioners. When you have a SEP, the business can write off its contributions. But employee contributions are pre-tax dollars, like a traditional 401k.
The Roth Solo 401k plan works like any employer plan would – contributions are made with after-tax dollars. You can’t take a deduction on your income taxes. The annual 2021 contribution limits are still $19,500 per year or $26,500 for people over 50.
The other thing about a Roth Solo 401k is you can take a loan against your contributions. Participants can borrow up to 50% of the account’s value or $50,000 – whichever is less. The loan has a 5-year-term with an attractive interest rate. The loan can be taken for any purpose, including paying off debt or funding a side business.
The strategic advantage of any Roth 401k account is tax-free investing. Once you’re eligible to withdraw funds, you can invest in real estate, precious metals, stocks, cryptocurrency. Tax-free. For sole proprietors, it’s an opportunity to make investments on a larger scale. For a one-person LLC, the contributions might be deductible if they’re paid by the business. Check with your accountant or tax attorney.
Get a Plan
When you sign on to a Roth 401k plan at work, your employer has made the decisions for you. When you set up a Solo plan, you need to make some decisions. To start a Roth Solo 401K account, you need to find for a 401k plan that has it as an option. That means you need to choose a brokerage that offers it. This list gives you 5 of the best plans. Look at fees and what funds they invest in.
A Roth 401k is an after-tax retirement fund offered as an alternative to a traditional 401k.
Contributions to the traditional fund are pre-tax. Contributions reduce the account holder’s gross income. They are not taxed when made, but when the money is withdrawn. The Roth 401k is exactly the opposite. Contributions do not reduce gross income, but when withdrawn they are tax-free.
The advantage of a traditional 401k is larger paychecks and lower taxes for employees. They control more of their money upfront. The advantage of a Roth 401k is tax-free investing, once the withdrawal criteria are met. Account owners can pull large sums of tax-free money to invest in stocks, real estate, or bitcoin.
The most important thing about a 401k is that you have one and contribute as much as you can.
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