Definition, tax implications, rules, benefits
A 401 (k) is a type of employer sponsored retirement plan that allows you to invest your income and grow it over time. There are two types: the traditional 401 (k), which is funded by pre-tax income, and the Roth 401 (k).
You fund Roth 401 (k) s with money you have already paid income taxes on. This allows you to withdraw funds from the account tax free in retirement.
âA Roth 401 (k) is a great option for anyone looking to create a source of tax-free retirement income,â says Matthew Stratman, senior financial advisor at South Bay Planning Group.
How does a Roth 401 (k) work?
The Roth 401 (k) has been around since 2006 and is designed as a hybrid of the traditional 401 (k) and the Roth IRA.
Like a traditional 401 (k), a Roth 401 (k) is employer sponsored. An employer sets the plan, chooses investment options, and then offers the plan to individual workers. The main difference between the two types is how the tax benefits work. A Roth 401 (k) can be beneficial if you expect your tax bracket to be higher in retirement.
There are exceptions, of course. To withdraw funds tax-free, you must be at least 59 Â½ years old and have had the account for five years or more. This rule applies to all Roth accounts.
There are also rules regarding contributions. For 2021, you can contribute up to $ 19,500 per year, plus an additional $ 6,500 if you are 50 or older.
What are the advantages of a Roth 401 (k)?
The big advantage of a Roth 401 (k) is that it allows you to make tax-free withdrawals in retirement. If tax rates go up or your tax bracket is higher at this time, it could mean significant savings in the long run.
âMany people with a pension, a large investment portfolio, or a side job may find that their income continues to increase even after they retire from 9 to 5,â says Stratman. “Taxes may go up soon, so a Roth could be a great way to take advantage of today’s low tax rates and opt out tax-free in the future.”
Another advantage is that your money also grows tax free. Since a Roth 401 (k) is funded with after-tax dollars, you won’t pay any tax when withdrawing, even on the money you earn by investing.
âThis can be important, especially if you factor in the compound growth that is likely to occur,â says Maggie Gomez, Certified Financial Planner and Founder of Money with Maggie. “In a sense, all of this growth is free money that isn’t taxed.”
Roth 401 (k) vs. traditional 401 (k)
Since the main difference between a Roth 401 (k) and a traditional 401 (k) is when the money is taxed, the main consideration when choosing between the two is your current tax bracket and the place where you’d expect it to be right down the line. With the Roth 401 (k), you pay taxes on the money before you put it into the account. With a traditional 401 (k), your contributions reduce your taxable income for that year and you pay taxes on withdrawals later in life.
âAt the start of your career, your salary is probably lower, which means your tax rate is also lower,â says Phil Weiss, director of Learned Wealth Management. “As you work longer and your income increases, your tax rate will likely increase. This makes the tax deferral that comes with contributing to a traditional 401k potentially more valuable.”
Here is what the two retirement accounts correspond to:
The financial report
The Roth 401 (k) have a major tax advantage, especially if you expect your tax bracket to increase in retirement. They also allow your money to grow tax-free.
If your employer offers a Roth 401 (k) option, think carefully about your career path and financial goals before deciding to open one. In some cases, you may be able to have both a Roth 401 (k) and a traditional 401 (k) simultaneously. Be sure to ask your tax advisor or financial planner if you need more personalized advice.