As we begin the new year, changes are made across different aspects of our lives. Some everyday examples can include personal life changes, commitments to health and fitness, or even adjusting your qualified retirement plan deferrals and the corresponding tax-treatment. Okay, perhaps that’s not everyone’s new years resolution, but that’s why we are here today. Whether you are starting a new job or just reviewing your current retirement saving strategy, here is why you could consider making deferrals into a Roth 401K.
What is a Roth 401K?
In 2022, an employee may elect to defer (contribute) up to an aggregated amount of $20,500 or $27,000 for ages 50 and up, per year across all retirement plans (401Ks, Roth 401Ks, 403(B), 457(B), etc). Employers may contribute until total annual contributions in the plan reach $61,000 or $67,500 for those 50 or older.
If your employer offers a 401K as a benefit of employment, a Roth 401K is a sub-account that may be offered within that retirement plan. A Roth 401K is funded only with employee post-tax deferrals from your paycheck.
Your employer may offer a match up to a certain percentage of your salary, but they are only allowed to make contributions to your Pre-Tax (traditional) 401K account and not the Roth portion of your 401K.
For example, if you defer 4% of your salary of $50,000 into a Roth 401K (and your employer matches up to 4%) your contributions will go toward your Roth 401K, but your employer’s matching contribution must be put into your pre-tax (traditional) 401K.
A Roth 401k requires mandatory minimum distributions at age 72 similar to traditional 401Ks and Traditional Individual Retirement Accounts (IRA). The Roth 401K is separate from the Traditional/Roth IRAs, as these separate classes of accounts have their own contribution limits and qualifications for individual use.
How does it work from a tax perspective?
For Traditional 401Ks, contributions are taken out of your pay before you receive your check, and it reduces your taxable income since you technically did not receive that portion of income yet. They are also not subject to tax until funds are distributed since the income was deferred into the pre-tax 401K account (excluding loans and rollovers/special circumstances).
With a Roth 401K, contributions are taken from your paycheck before you receive it, however you would still pay tax on your total annual income when you file your taxes. Your taxable income is not reduced, even though you do not have direct access to the funds, and you have now put those contributions into the Roth 401K.
For example, if you make $60,000 annually and defer $5,000 from your total pay into your Roth 401K, you will not reduce your taxable income after making this deferral. With a Traditional 401K, if you defer $5,000 into your 401K, you will end up reducing your taxable income by $5,000.
What are the benefits of a Roth 401K?
If you defer $5,000 into your Roth 401K today and pay for the tax in April when you file federal taxes, you can potentially receive two benefits if you wait until retirement to access the funds.
The first benefit is that since you paid for the tax today, you now have the opportunity for tax-free growth. If your retirement plan experiences good returns, then it is possible you may realize a higher tax-equivalent gain after considering how much you paid in taxes today versus paid later in retirement.
The second benefit is that if you wait for qualifying circumstances to withdraw from the Roth 401K (typically retiring and reaching age 59 ½) then you will not create a taxable event upon distribution. Since you paid the tax today rather than later, you will have tax-free income later in life from the Roth 401K.
When would someone want to choose a Roth 401k over other options?
Your projected current income tax bracket and projected income tax bracket in retirement, would play a heavy factor into deciding if you want to contribute to a Roth 401K. Paying for tax-free growth at a low-income tax bracket today is more favorable than paying at an average tax rate later in retirement with a large distribution.
For example, if you have a Required Minimum Distribution (RMD) of $80,000 from a Traditional 401K and that is your only source of taxable income in retirement, using todays tax rates (filing single in 2021), you would pay slightly over $13,000 in taxes.
If this RMD were required to be taken from a Roth 401K, you would not have realized income or paid the $13,000 in taxes. The ultimate question then becomes whether you paid less tax today or in retirement.
Another consideration is to see if you might create tax savings today if you defer income in a traditional 401K as opposed to contributing to a Roth 401K. If deferring the annual limit to a traditional 401K can bring an individual down into a lower tax bracket or reduce your tax liability, then it may be worth comparing the tradeoff of tax-free growth and tax savings now for higher income tax bracket individuals.
In conclusion, consider the previous points and how they may impact your overall financial plan. All tools are not universal in their use, and the Roth 401K is no exception. By understanding how the Roth 401K is effectively used, this tool can make an impact from your monthly pay to your retirement in 20 years, if used appropriately.