Retirement planning can confuse the average investor, with so many tools available. However, with adequate information and proper understanding, one can effectively plan for retirement. To help you in this, let’s discuss a popular retirement vehicle — a Roth 401(k) plan.
A Roth 401(k) is a retirement plan offered by an employer where qualified employees make after-tax contributions to a Roth account and are allowed tax-free withdrawals at the time of retirement.
Roth 401(k)s are considered to have the best of both instruments — a Roth IRA and a traditional 401(k). Let’s take a look at some facts about this retirement vehicle.
The IRS allows employees to contribute up to 100% of their income to a Roth 401(k) plan, though it would be wise to adhere to the maximum employee contribution limit. Notably, the maximum employee contribution for 2019 has been raised to $19,000 from $18,500 in 2018. Moreover, if you are 50 years or older, you can make a “catch-up” contribution of an extra $6,000 a year. However, one should remember that contributions to Roth 401(k)s are on an after-tax basis. This means that one will not be able to deduct contributions from their taxable income.
One can simultaneously contribute to other retirement plans. Under IRS regulations, contributions to all retirement plans should not exceed $56,000 for 2019 (up from $55,000 in 2018) or 100% of the participant's compensation, whichever is lower. Meanwhile, the maximum annual contribution limit for 401(k) participants (traditional or Roth), aged 50 years or older, is $62,000 for 2019.
Employers offering a Roth 401(k) plan are not obligated to make matching contributions to the plan on behalf of their qualified employees. Notably, employer matches are made with pretax dollars. These funds will accumulate in a separate pre-tax account with taxable distributions at the time of retirement.
[Did you know? This particular feature of a Roth 401(k) combines the taxation rules of both the traditional 401(k) and the Roth IRA instruments].
With Roth 401(k)s, you don’t need to pay taxes on qualified distributions in retirement. Let’s take a look at the following example to understand the withdrawal system better: Mr. X has $1 million in his nest egg at the time of retirement. The tax rate applicable for him is 22%. His takeaway amount will be $1 million in the case of Roth 401(k) as withdrawals under this are tax-free.
Required Minimum Distributions
One must begin taking required minimum distributions, or RMDs, after turning 70½ from Roth 401(k)s.
[Tip to consider: You may roll your Roth 401(k) funds into a Roth IRA to avoid RMDs. This is particularly helpful when you are planning tax-free distributions for your heirs.]
Access & Early Withdrawal Penalties
You need to maintain a Roth 401(k) account for at least five years before withdrawing money. Something to note is that the early withdrawal penalty of 10% is on investment earnings only.
[Quick tip: One may avoid paying penalties by opting for a loan from their Roth 401(k) and repaying it on time.
Also, Roth 401(k)s do not classify as a “first-time home purchase” (as defined by the IRS) under its qualified withdrawals section. Using your Roth 401(k) dollars for the same may result you in paying taxes.]
In-plan Roth Rollovers
Sometimes there are plans which allow for in-plan Roth rollovers from the pre-tax portion of your traditional 401(k). These include rolling over salary contributions, matching contributions, and profit-sharing contributions to your Roth 401(k). Then, rolling over will result in taxable income in the transaction year.
[FYI: These in-plan Roth rollover transactions are irreversible unlike Roth IRA conversions. So, it is advisable to be cautious while making such moves].
Future Tax Brackets
If you see yourself retiring in a higher tax bracket, then consider maxing out your Roth 401(k) contributions. Thus, if your tax rate rises, your savings will be worth more at the time of retirement.
However, if you see yourself in a lower tax bracket at retirement, you should consider contributing to other tax-deferred programs.
Since it is not easy to predict tax rates, hedging yourself against changing tax rates by parking money in both tax-deferred vehicles and Roth 401(k) accounts is something to consider.
Roth 401(k)s are becoming increasingly popular, thanks to easier access. Per a Transamerica Annual Retirement Survey 2016 report, when given an option, six in 10 workers chose to contribute to Roth 401(k)s.
A Simple Way to Build Wealth
No matter what your financial goals are, investing in quality stocks is an option worth considering. Stocks have produced better returns than other kinds of investments over the years and generated significant wealth for shareholders. If you're interested in stocks but you're nervous about picking the right ones, Zacks can help. Our research team makes it simple to find long-term buys with long-term wealth-building potential. Starting today, you can see our private selection of stocks priced under $10, Warren Buffett-style value picks, dividend stocks and more. Click here for your sneak peek >>