A Roth 401k is a retirement plan that has recently gained popularity. This plan offers significant benefits that could save you thousands of dollars in taxes during retirement. This guide will discuss a Roth 401k, how it works, and the pros and cons of using this type of plan for retirement savings. We even include a free Roth 401k Calculator to estimate withdrawals.
What Is A Roth 401k?
A Roth 401k is an employer-sponsored retirement plan funded by after-tax dollars. It shares similarities with a traditional 401k and a Roth IRA, but there are also some significant differences between the three investment options.
Traditional 401k vs. Roth 401k
The key to understanding the difference between a Roth 401k and a traditional 401k is taxes and when you pay them.
With a Roth 401k, you contribute to the account with money already taxed, so-called post-tax contributions. When you withdraw from your Roth 401k later, you don’t have to pay any income tax.
A traditional 401k has you contribute an amount pre-tax, meaning the contribution is deducted from your paycheck before income taxes. Your taxable income for today lowers, but when you take qualified distributions during retirement, withdrawals will be taxed as regular income.
Choosing a Roth vs. Traditional 401k depends on when you want to face income taxes. Consider if you will be in a higher tax bracket now, as contributions are being made, or further down the line when withdrawals happen during retirement.
- A traditional 401k could be a more beneficial strategy if your taxes are expected to decrease during retirement. By contributing now, you can avoid higher taxes and pay less when taking distributions later.
- A Roth 401k may be best if you anticipate lower income taxes. You’ll pay lower taxes on contributions now and won’t have to worry about higher taxes later. If you’re starting out your career with a low salary and tax rate, contributing to a Roth 401 (k) is likely the wiser choice.
If your employer offers matching 401k contributions, it is essential to note that they must go into a traditional 401k account. Even if you’ve chosen to put your money in a Roth 401k, any employer matches will still be placed in a separate traditional account.
Roth 401k Contribution Limits
The contribution limits for Roth 401ks, and traditional 401ks are the same. The maximum employee contribution is $20,500 for 2022; this amount will increase to $22,500 in 2023. For employees who are 50 or older, there is an additional catch-up contribution of $6,500 in 2022 and $7,500 in 2023.
401k Employee Annual Contribution Limits
| Contributions | 2022 Limit | 2023 Limit |
|---|---|---|
| Maximum Employee Contribution | $20,500 | $22,500 |
| Catch-Up Contributions for those 50 or Older | $6,500 | $7,500 |
The combined annual contributions to a Roth 401k and traditional 401k account cannot exceed set limits.
In 2022, the combined limit between employer matching contributions and employee contributions was $61,000 or 100% of an employee’s compensation- whichever number is lower. The combined limit for employees over 50 years old in 2022 is $67,500-$6,500 more than other employees due to the catchup contribution provision. In 2023, the maximum allowable amount goes up to $66,000 or $73,500 if you are 50 or older.
Total 401k Employer and Employee Annual Contribution Limits
| Contributions | 2022 Limit | 2023 Limit |
|---|---|---|
| 401k Employee & Employer Contributions | $61,000 | $66,000 |
| Total Contributions With Catch-Up Contributions (50 or Older) | $67,500 | $73,500 |
Employer contributions that do not reach the total contribution limit in a year may be supplemented with non-Roth, after-tax contributions to a traditional 401k plan.
Roth 401k Withdrawal Rules
Withdrawals from a Roth 401k can be classified as qualified distributions, hardship distributions, and non-qualified distributions. Remember that each type has different rules, which come with their own advantages and disadvantages.
To start making distributions from your Roth 401k, you must meet two conditions: be at least 59 ½ years old and satisfy the five-year rule. The five-year rule states that your first contribution to the account must have been made at least five years before making any withdrawals. However, if you retire and roll your Roth 401k balance into a Roth IRA that has been open for more than five years, the required 5 years will already have passed.
If you start contributing to a Roth 401k at age 58, you can withdraw without being subject to penalties until you’re 63.
You can withdraw money from your Roth 401k in cases of hardship, depending on the rules set by your specific plan. These instances include:
- To pay for medical expenses that exceed 10% of your adjusted gross income, you may be eligible to deduct them from your taxes.
- If you become permanently disabled,
- If you are a member of the military reserves and have been called to active duty.
- If you leave employment at age 55 or older.
- A Qualified Domestic Retirement Order is part of a divorce or court-approved separation.
Your Roth 401k beneficiary can access the total account balance without penalty if you die.
Roth 401k Early Withdrawals
Even if you don’t meet the above conditions, you can still withdraw money from your Roth 401k account. However, these types of withdrawals are considered to be non-qualified distributions.
If you’re not 59 ½ and don’t want to wait five years after making your first contributions, note that you may have to pay income taxes and a 10% IRS tax penalty on some of the money you withdraw.
The contributions and earnings must be included to withdraw money from your Roth 401k. The amount available for withdrawal will depend on the ratio of contributions to earnings within the account.
Although you may have to pay fewer penalties by withdrawing money from your Roth 401k during difficult times, giving up your retirement savings is still not a good idea. Early withdrawals should always be a last resort when compared with other alternatives.
Roth 401k RMDs
Required minimum distributions (RMDs) must be taken from your Roth 401k by April 1st of the year after you turn 72, similar to a traditional 401k. Your annual RMD amount is based on your account balance and life expectancy.
Withdrawing money from your retirement account is a delicate process. You want to ensure you’re taking out enough to live comfortably but not so much that you deplete your savings too quickly. A financial advisor can help you create a withdrawal schedule meeting all these criteria. They can also help you balance your RMDs and withdrawals with Social Security benefits to ensure you maximize your retirement income sources.
If you’re 73 years old, one method of avoiding RMDs is rolling your Roth 401k into a Roth IRA. Although, it’s crucial to remember that if you deposit the funds into a newly opened Roth IRA, you may have to wait five more years before taking any qualified withdrawals. However, If you roll the money over into an already existing Roth IRA that has been open for at least five years, there is no waiting period.
Roth 401k Loans
Although Roth 401k loans are uniform across employers, each employer can offer this benefit. Some employers also limit eligibility for a 401k loan based on employee seniority.
Although 401k loans may have potential benefits, they also come with risks. For example, if you are laid off or quit your job while your loan is still outstanding, you must repay the loan in taxes the following year. Taking advantage of all possible extensions would mean having until October 15th of next year to repay the loan; otherwise, any remaining balance is considered a non-qualified early withdrawal and subject to a 10% tax penalty.
Roth IRA vs. Roth 401k
Although both Roth 401ks and Roth IRAs are funded through after-tax contributions, there are essential distinctions between these two retirement accounts that you should be aware of:
- Annual Contributions. The $6,000 Roth IRA contribution limit for 2022 allows an additional $1,000 contribution from people 50 or older by year-end. However, it’s crucial to remember that people’s 401k annual contribution limits are much higher. Employer contributions to a traditional 401k must also be considered when planning for retirement savings.
- Income Limits. Although anyone at any income level can contribute to a Roth 401k, income limitations exist for those who want to contribute directly to a Roth IRA. To be eligible, your modified adjusted gross income (MAGI) for 2022 cannot exceed $144,000 if you’re single or $214,000 if you’re married.
- Limited Availability. You can open a Roth IRA if you satisfy the eligibility and income requirements, with no limit on how much you contribute. You can only get a Roth 401k from an employer.
- RMDs. When you reach the age of 72, you are required to take RMDs from a Roth 401k. However, if you have a Roth IRA, there are no RMDs—you can leave the entire balance in the account and pass it down to an heir. (Remember that if you inherit a Roth IRA from anyone other than your spouse, you may still be subject to RMDs.)
- Early withdrawals. If you have owned a Roth IRA for more than five years, generally, you may withdraw your contributions without being charged a penalty before the age of 59½. Withdrawing earnings typically trigger the 10% tax penalty, however. Taking money out of a Roth 401k is more complicated and is described in detail above.
- Roth 401k loans. When you want to access the money in your Roth 401k and don’t qualify for an early withdrawal, taking out a loan from your account is always an option. On the other hand, that cannot be done with a Roth IRA.
Roth 401k Savings Calculator
Roth 401k Withdrawal Calculator
An annuity is an insurance policy that provides a retirement income for the rest of your life, even after other savings runs out. Automating this process with an annuity can give you much-needed peace of mind in knowing one less thing to worry about in retirement.
Note: You can purchase an annuity (with no tax penalties) with your traditional and Roth 401k, IRAs, retirement accounts, investments, and cash.
Related Guide: 401k Withdrawal Calculator
Roth 401k Withdrawal Comparison
The table below compares using an annuity to distribute your income by systematically withdrawing from retirement plans yourself or through financial advisors.
| Features | Annuity | 401k | IRA | Roth IRA |
|---|---|---|---|---|
| Withdrawal Percentage | 5.20% – 6.55% | 4% | 4% | 4% |
| Can Income Increase? | Yes | Yes | Yes | Yes |
| Can Income Decrease? | No | Yes | Yes | Yes |
| How Long Will Money Last? | Lifetime | 30 Years+ | 30 Years+ | 30 Years+ |
| Annual Fees | 0 – 1.50% | 1% – 4% | 1% – 4% | 1% – 4% |
| Taxation | Taxable/Tax-Free | Taxable | Taxable | Tax-Free |
| Death Benefit | Account Balance | Account Balance | Account Balance | Account Balance |
Example: A 60-year-old retiree starts withdrawing immediately from their $1 million portfolio, they would receive:
Next Steps
A Roth 401k is an excellent retirement savings plan that offers many benefits, including tax-free withdrawals in retirement. If you want to save on taxes during retirement, a Roth 401k may be the right option. With our free Roth 401k Calculator, you can estimate your future withdrawals and see how much money you could save using this plan. Contact us today for a quote and to learn more about how we can help you save on taxes during retirement.
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