You may have heard of a Roth IRA. But a Roth 401(k)? What’s that?
A Roth 401(k) is a relatively new type of retirement plan, first offered in 2001. As more employers start to include this option in their benefits packages, according to reports, employees are taking advantage. In essence, a Roth 401(k) combines the benefits of a Traditional 401(k) with those of a Roth IRA.
Since 401(k) plan management is one of our focuses here at Scarborough Capital Management, we wanted to address some commonly asked questions – how does a Roth 401(k) differ from a Roth IRA, what are the potential benefits and drawbacks of opening a Roth 401(k), and ultimately, how do you know if a Roth 401(k) is right for you?
What is a Roth 401(k)?
A Roth 401(k) is very similar to a Traditional 401(k). Both are employer-sponsored retirement plans that allow you to contribute up to $23,000 for the year 2024. (If you’re at least age 50, you can save an additional $7,000 in catch-up contributions.)
But here’s where they differ.
With a Traditional 401(k), you fund your account with pre-tax dollars and you pay taxes on the money in retirement. With a Roth 401(k), you do the opposite. You pay taxes on your contributions upfront and enjoy tax-free withdrawals in retirement.
Roth 401(k)s can be a good option to consider if you think you’re in a lower tax bracket now than you will be in retirement. In that case, by paying taxes on the money upfront, you could theoretically pay fewer taxes in the long-run. If converting a Traditional IRA to a Roth IRA, you will owe ordinary income taxes on any previously deducted Traditional IRA contributions and on all earnings. We suggest that you discuss tax issues with a qualified tax advisor.
How is a Roth 401(k) Different from a Roth IRA?
There are two main ways Roth 401(k)s differ from Roth IRAs: Income restrictions and withdrawal rules.
Unlike Roth IRAs, Roth 401(k)s don’t have income restrictions. You’re eligible to participate as long as your employer offers one; it doesn’t matter how much money you make. With a Roth IRA, on the other hand, you’re not eligible to contribute if you make more than $230,000 as a married filer or $146,000 as a single filer.
Another difference: Roth IRAs typically have more lenient withdrawal rules than Roth 401(k)s. There are also several penalty-free exclusions with Roth IRAs. For example, you won’t get penalized if you withdraw money to pay for:
- Out-of-pocket medical expenses not covered by insurance
- Qualified education expenses for you, your spouse or a child
- A permanent disability
- A first-time home purchase (you can take out up to $10,000)
Roth IRAs do have a waiting period on certain withdrawals, known as the five-year rule.
The five-year rule applies to three situations: if you plan to withdraw account earnings, if you converted your traditional IRA to a Roth, or if a beneficiary inherits a Roth IRA.
Failure to adhere to the five-year rule could result in paying income taxes on earnings, withdrawals, and a 10% penalty.
With a Roth 401(k), you may only qualify for a penalty-free withdrawal if you have a Coronavirus-related hardship (under the CARES Act) or another type of hardship, such as a burial or funeral, home destruction due to a natural disaster, or a foreclosure.
Have questions that aren’t addressed here? Contact the Scarborough Capital Management team.
Potential Benefits of a Roth 401(k)
There are several potential benefits to a Roth 401(k):
- No income limitations. Unlike Roth IRAs, you can contribute to a Roth 401(k) even if you make more than $230,000 as a married person filing jointly or $146,000 as a single filer.
- Higher contribution limits. You can contribute up to $23,000 a year (or $30,000 if you’re at least age 50) in a Roth 401(k). The limit for Roth IRAs is $7,000 (or $8,000 if you’re at least 50).
- Tax advantages. A Roth 401(k) will typically work in your favor if you anticipate being in a higher income tax bracket in retirement than you are now.
- Can take out a loan if needed. If your employer allows 401(k) loans, you can tap into your Roth 401(k) to borrow up to $50,000 or 50 percent of your vested balance (whichever is less).
Drawbacks
If you’re considering opening a Roth 401(k), here are a few caveats to watch out for:
- May not be available to you. It’s up to your employer whether they offer a Roth 401(k). If it’s not offered at your job, you won’t be able to contribute to this type of plan.
- Must take RMDs. Unlike Roth IRAs, you must start taking Required Minimum Distributions (RMDs) on your Roth 401(k) when you turn age 72. The only exception is if you’re still working at your company or own 5 percent or more of the business. You could also rollover your Roth 401(k) into a Roth IRA where RMDs are not required.
- Investments may be limited. Your investment options may be more limited in a Roth 401(k) than they are in a Roth IRA. This is because plan sponsors get to choose which investment vehicles make up a 401(k).
- Less flexibility for early withdrawals. With a Roth IRA, you can withdraw any of your principal balance at any time, as long as you meet the five-year rule guidelines. With a Roth 401(k), this isn’t the case. You must qualify for some type of hardship withdrawal to avoid the 10 percent penalty.
How to Find Out if a Roth 401(k) is Right for You
Retirement plans can be tricky. Rules and restrictions differ. Elements of your personal life can change your goals and concerns. When it comes to 401(k) plan management, there are important principles to consider.
If you’re not sure if a Roth 401(k) is the right investment vehicle for you, talk it over with a financial advisor. Understand your options. Discuss what each plan looks like based on your specific situation. Consider your current income. Understand your tax bracket. Review your other investments. Lean on a financial advisor to help you choose the right plan for you.
If you’re currently looking for a financial advisor in Annapolis or feel it’s time to make a change, let’s talk.
This is for informational purposes only, does not constitute investment advice, and is not legal or tax advice. Please consult the appropriate professional regarding your individual circumstance. Scarborough Capital Management cannot verify the accuracy of, nor assume responsibility for any content of linked third-party sites. Information available on third-party sites is for informational purposes only.
