This article aims to provide you with answers to the question “What is a Roth 401k?”, and indicate its advantages and disadvantages. So, how does a Roth 401k plan work? A Roth 401k provides you with a way to save for retirement. Since the taxes are applied against the contributions, and not the withdrawals, your money grows tax-free and you can save money if you enter a higher income bracket at retirement.
However, if you plan to have a lower income at retirement, a Roth 401k would cost you more in taxes. Furthermore, since it is difficult to determine the future of tax laws, it may be a better option to diversify your investments between pre-tax and post-tax retirement accounts. Read on to learn more about this retirement saving plan.
The Concept of a Roth 401k
A Roth 401k is a type of investment savings account sponsored by an employer for their employees. This type of account is commonly used to invest for retirement savings. You contribute to the account during your working years, up to the contribution limit of the plan. Once you reach the age of 59 1/2 years and hold the account for more than five years, you can begin withdrawing from the account tax-free.
What is a Roth 401k in comparison to a traditional 401k? The major difference between a traditional 401k and a Roth 401k is at what point in time they are subject to taxes. In a Roth 401k, taxes are applied at the time of contribution. For this reason, the contributions are referred to as pre-taxed.
You can read also: What Is a 401(k)?
What is a Roth 401k, as far as how long has it been around? This particular type of investment savings account was first created in 2001, as part of the Economic Growth and Tax Relief Reconciliation Act of that year, as an alternative to those who wanted their contributions to be pre-taxed, as opposed to being taxed upon withdrawal, which is what occurs with a traditional 401k.
If you contribute regularly to a Roth 401k, your contributions will be invested in a set of investments, typically mutual funds, but in some cases, you can invest in specific stocks. The level of control that you have over your investments varies, as do other features, such as how long it takes for your funds to become vested, that is, when you are entitled to the money even if you leave the company.
Advantages and Disadvantages of a Roth 401k
How does a Roth 401k plan work? Why would someone want to contribute to a Roth 401k? Well, one reason they do this is so that no tax is incurred upon the money when it is withdrawn. There can be pros and cons to this, depending upon changes in tax laws or changes in your personal income. Since many of the benefits of the Roth 401k depend upon your future tax situation, it can be hard to determine precisely whether a Roth 401k will be right for you. What is a Roth 401k when it comes to benefits and disadvantages?
Advantages of a Roth 401k
- Contributions are pre-taxed, which means withdrawals are tax-free. If you plan to be in a higher income bracket when you retire than are you now and if this plan comes to fruition, this would reduce your tax bill when you retire.
- You never know when income taxes may go up. Paying taxes on your contributions now may mean a lot of savings if income tax rates go up or if the structure of everyone’s tax brackets change in a way unfavorable to your future situation.
- Many employers match your contributions up to a certain level. This is essentially like free money. However, many companies put restrictions on when this match is fully considered available for you to withdraw even if you meet the distribution requirements. This limitation of when you fully possess the funds is known as vesting.
Disadvantages of a Roth 401k
- Since contributions are pre-taxed, if you plan to have a lower income upon retirement than you have during your working years, the Roth 401k may provide a disadvantage when it comes to paying taxes on your contributions if you actually do go down one or more tax brackets.
- It is hard to say what income tax levels and tax brackets will look like in the future. It’s possible that your tax rate may go down or the structures of the tax brackets may be changed in such a way to where your tax rate is actually lower without any change in income. This would make a Roth 401k less desirable than a traditional 401k. This scenario is where a strategy of diversification may make more sense.
- Your company may not offer good fund selections with their Roth 401k. If the funds you have to work with don’t offer good returns, you may be able to grow your retirement income more efficiently somewhere else.
- Really high fees can also eat up any returns or savings you may gain from utilizing a Roth 401k. Make sure your annual fee is factored into your calculations when considering your investment goals and ensure that the funds you select within the account don’t have high administrative fees.
We hope that this article has provided you solid answers to the question “What is a Roth 401k?”, so that you can understand why it was created and where it fits into the puzzle of retirement savings.
Did we give you all the answers you were looking for to the question “What is a Roth 401k?” Have you had any experiences with Roth 401k’s? If you have any thoughts, comments or questions, feel free to let us know.