When most Americans are accumulating their retirement savings, they use a 401(k) plan or a similar plan that also decreases their taxable income. The downside, which seems so far away when you are preparing for retirement, is that when you do start taking withdrawals, you have to pay taxes on that income. There is a way to switch that around, if you meet the criteria.
CNBC’s recent article, “A Roth 401(k) offers tax advantages. Here's how it works” says that more employers are offering another option for your retirement savings—a Roth 401(k). When you contribute to a Roth 401(k), the contribution won't lower your taxable income today. However, when you withdraw money in the future, like a Roth IRA, it's tax-free. A Roth 401(k) lets you save much more than a Roth IRA. You can only contribute $6,000 to a Roth IRA, and if you're age 50 or older, you can make an additional catch-up contribution of $1,000.
401(k) plans are more liberal with what you can save. The limit is $19,000 a year to a 401(k) in 2019, and Roth 401(k) plans share that limit. If you are over age 50, you can save an additional $6,000. However, the amount you earn also makes a difference. Roth IRAs have an income cap. You can't contribute to a Roth IRA, if you earn more than $203,000.
The biggest negative with a Roth 401(k) is how contributions might affect your tax liabilities today. If you earn $100,000 a year and save $19,000 to a traditional 401(k), your taxable income would be only $81,000. However, by contrast, if you make the same $19,000 contribution to a Roth 401(k), you'll still have taxable income of $100,000.
There are no tax consequences when you take money out of a Roth 401(k), when you're 59½ and you meet the five-year rule. However, if you take a similar distribution from a traditional 401(k) plan, the money you withdraw is subject to ordinary income tax.
There are also required minimum distributions (RMDs). Roth 401(k) account owners have to take the RMD at age 70½. This is not for Roth IRA owners. Therefore, you may want to roll your Roth 401(k) account over to a Roth IRA account, before you turn 70½.
Whatever kind of retirement savings plan your employer offers, don’t miss out. Both traditional IRAs and Roth offer a chance to save through automatic payroll deductions. If you work for a company with a matching program, that’s free money. You might want to consider splitting your contributions 50/50 to take advantage of the tax-free growth, without giving up all of the advantages of pre-tax savings.
Reference: CNBC (April 23, 2019) “A Roth 401(k) offers tax advantages. Here's how it works”