Tax-advantaged has quite the ring to it, doesn’t it? Unlike the tax-advantages a traditional 401(k) offers—funded with pretax wages—a Roth 401(k) is funded with after tax wages. Income tax has already been paid so when it comes to withdrawing in retirement, your money is withdrawn tax-free.
What exactly is a Roth 401(k)? Created in 2006, Roth 401(k)s are employer-sponsored retirement savings accounts that use after-tax money.
How They Work
While employer-sponsored, enrollment and participation in Roth 401(k)s is entirely voluntary. Payroll deducts the special funds after taxes have been taken out each paycheck. Some employers may offer matches for Roth 401(k)s.
In comparison, a traditional 401(k) and a Roth 401(k) have different tax-advantages. A traditional 401(k) reduces an employee’s gross annual income, providing a tax break now. However, regular income taxes will be due upon withdrawal during retirement. A Roth 401(k) requires income tax be paid but reduces an individual’s annual net income. But after the money is placed into the Roth account, no further taxes are owed when taken during retirement—this includes profits earned.
Much like the traditional 401(k), a Roth 4010(k) is subject to contribution limits and is based off the investor’s age per guidelines of the IRS. For 2022, an individual may contribute up to $20,5000. Those over 50 are permitted a catch-up contribution of $6500. Another perk Roth 401(k)s offer is no income limit.
Withdrawal Special Considerations
Certain criteria must be met for withdrawals to be tax-free.
- The Roth 401(k) must be at least 5 years old.
- Withdrawals must occur when the account holder is at least 59 ½. If before, account holder must has passed or experiencing qualifying disability.
Roth 401(k)s do require required minimum distributions. Once you are 72 the first RMD from your Roth 401(k) must be taken by the first April after you turn 72. If you are still working for the company who sponsors the retirement account, you may hold off taking a distribution.
Advantages and Disadvantages Summary
- Helps those who may be in a higher tax bracket during retirement (which is commonly seen)
- Distributions are tax-free.
- Earnings grow tax-free.
- Uses after-tax dollars, meaning during working years you are out that money
- Contributions do not limit taxable income
Roth 401(k)s and Market Volatility
Sadly, you can lose money since a 401(k) is an investment into the market. However, most employers offer low-risk options like government bonds. You are always welcome to work with the plan sponsor and stir up your investment yield and risk.