If the Roth IRA and the 401(k) had a baby, the Roth 401(k) would be the result. Introduced in 2006, the Roth 401(k) is a retirement savings tool that’s gaining popularity. According to a survey by human resources consulting firm Aon Hewitt, 29% of employers say they are very or somewhat likely to offer this option in the next 12 months.
If you’re looking for a way to make after-tax contributions to a 401(k) plan, the Roth 401(k) might be worth investigating. But should you take a chance? The following are some benefits and pitfalls of investing in this retirement vehicle.
Withdrawals are tax-free
Since traditional 401(k) contributions are tax-deductible, you are able to deduct the contribution amount from your taxable income, thereby reducing your income tax liability. This is quite beneficial if you are in a high income tax bracket. The drawback, however, is that a 401(k) delays your tax liability rather than doing away with it altogether. Consequently, withdrawals made during retirement will be taxable.
This is where the Roth 401(k) has an advantage over a traditional 401(k). Since Roth 401(k) contributions are made after-tax, withdrawals are tax-free. This also goes for investment earnings. If you happen to be in a higher tax bracket during retirement, this is good news for your wallet. You must be at least 59 ½ and have contributed to the plan for a minimum of five years to qualify for tax-free withdrawals.
Special situations allow for penalty-free early distribution
You can make tax-free withdrawals before age 59½ if you need funds as a result of a disability. Funds can also be transferred without a tax penalty to your heirs in the event of your death. This makes the Roth 401(k) a great estate planning tool. Do note, however, that if your employer offers a match you will have to pay taxes on that money. This is because matches are made on a pre-tax basis and are held in a separate account.
There are no income limitations
Regardless of your annual income, you can contribute to a Roth 401(k) up to the contribution limit, which is $18,000 if you are younger than 50 years old, and $24,000 if you are 50 or older. These are the same limits as a traditional 401(k).
This is not the case with a Roth IRA. For 2015 single taxpayers with a modified adjusted gross income above $131,000 cannot contribute. The same is true for married taxpayers filing jointly with a modified adjusted gross income above $193,000.
Contributions are not tax-deductible
If lowering your taxable income is important, the Roth 401(k) might not be right for you. In addition, be aware that if you have both a traditional and Roth 401(k), your contribution limit applies for both accounts, not each account. For example, you can’t contribute $18,000 to a Roth 401(k) and then another $18,000 to your traditional 401(k). Your annual contribution must be spread across both 401(k) accounts.
Minimum distributions are required
Just like a traditional 401(k), the Roth 401(k) is subject to required minimum distribution rules after you turn age 70½. You may have read otherwise, but this is not so. You will face harsh penalties if you do not withdraw money from your account at the set time.
Those who ignore the rules by not withdrawing the full amount, withdrawing late, or not withdrawing the minimum amount at all are subject a monstrous tax of 50% of the amount not withdrawn. However, if you are still working, you are not subject to the required minimum distribution.
If want to dodge the minimum distribution requirement, your best bet is a Roth IRA. The RMD rules do not apply to a Roth IRA while the account holder is living. You have the option of rolling your Roth 401(k) into a Roth IRA, but it is worth noting that the five-year holding period in order to qualify for tax-free withdrawals will begin with the start date of the Roth IRA.
Minimum distributions are required for all employer-sponsored plans. The IRS says that this includes profit-sharing plans, 403(b) plans, and 457(b) plans. Traditional IRAs and IRA-based plans are also included in the mix. If your employer does not offer the Roth 401(k), but you’re interested in participating in this plan, you can try asking if the company would consider offering this option.