In 2006 the Roth 401(k) was introduced as an option for employees participating in company 401(k) plans. A majority of businesses now allow for employees to decide between contributing to the Roth 401(k) or Traditional 401(k) (or both).
How do you know which is best for you? There’s no one size fits all solution, but see below for a few thoughts.
Roth 401(k)
- Similar in operation to a Roth IRA in terms of tax-free growth. The tax-free feature is helpful in retirement cash flow and estate planning.
- Estate Planning: Beneficiaries or heirs will not be taxed on these funds once received and withdrawn. They must empty inherited Roth account within 10 years of death.
- Unlike a Roth IRA – there is no income limit restricting contributions, and an individual can contribute up to the maximum 401(k) limit (this year up to $20,500 for those under 50).
- Taxes are applied on current contributions.
- Typically, those who are in a low tax bracket or believe their tax rates will increase in retirement are good candidates to consider the Roth 401(k).
- If the Roth 401(k) is rolled into a Roth IRA after retirement there is no Required Minimum Distribution beginning at age 72.
Traditional 401(k)
- A tax benefit is received on current contributions at the individual’s current ordinary income tax rate.
- For those in the highest income tax brackets, a contribution to the traditional 401(k) would provide the largest tax benefit.
- Contributions grow tax-deferred.
- Distributions in retirement are taxed at ordinary income rates.
- Required minimum distributions must start at age 72.
- Heirs or beneficiaries will be taxed at their ordinary income rates upon withdrawal, and they must empty the account within 10 years of original owner’s death.
Please let us know if we can help review and create your strategy around 401(k) contributions and future withdrawals.
Matt and Andrew
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* Consult with a tax professional before making any decisions regarding Roth contributions or conversions.