While workers are aware they have a choice in their retirement plans, many still don’t know the difference between a traditional 401(k) and a Roth 401(k) or which option is ideal for boosting retirement saving goals.
Few workers use the Roth 401(k) retirement plan, despite its advantages and growing availability. Since a 2006 law allowed the creation of Roth 401(k)s, more employers have been offering them and savvy workers who have been signing up laud the advantages. A Roth plan offers advantages for many retirement savers. It’s generally a more flexible tool than a traditional 401(k) and, for many younger and lower-paid workers, a Roth plan is a life-saver. However, deciding between a Roth and a traditional 401(k) isn’t easy. Trying to separate fact from fiction has left many people confused.
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Here are some benefits [and disadvantages] of Roth 401(k) plans.
With a traditional 401(k), there are no taxes on contributions. Instead, you pay taxes when money is withdrawn in retirement. A Roth reverses that: there’s no tax break on contributions, but all withdrawals–including any investment gains–are tax-free.
Tax breaks for young and low-income workers. With a Roth, workers trade some upfront pain for a long-term gain. They pay taxes on their retirement savings now so they don’t have to pay taxes on withdrawals in retirement. The young benefit most from this strategy, because they have more time to let their money grow tax-free. Workers can use Roths if they expect to earn significantly more later in their career. A low tax bracket now, minimizes the upfront pain of a Roth. The Roth will then help avoid taxes in retirement, when a person goes into a higher tax bracket.
Flexibility in retirement. Retirees in sound financial health also benefit from a Roth 401(k), because of the flexibility it offers. For instance, a retired couple can use a chunk of their cash to celebrate a signature event, such as a silver anniversary or a child’s graduation. Â If they take that money from a traditional retirement account they’ll have to pay taxes on it, and that one-time expense may bump them up to a higher tax bracket. But any withdrawals from a Roth 401(k) are tax-free, so retirees can cover big expenses without worrying about the tax consequences.
By law, retirees must make regular withdrawals–”required minimum distributions‖from their traditional retirement accounts after age 70 and a half. With a Roth, retirees can leave assets in a Roth account for as long as they want, which keeps investments growing tax-free well into retirement.
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Flexibility Before retirement. Unlike a traditional 401(k) plan, there’s no penalty for withdrawals from a Roth 401(k), as long as you take back only the amount of your original contribution and leave any earnings in the 401(k). That can make a Roth account valuable in emergencies or if you retire early.
A higher savings limit. Workers under age 50 can save up to $18,000 in a 401(k) account every year. Past age 50, they can save an extra $6,000. Those limits are the same for Roth and traditional accounts, but any after-tax dollars put in a Roth go farther, because you still owe taxes on any money put in a traditional account. That makes Roth plans a nice option for workers who want to put as much money in their retirement accounts as possible.
Employer Match Formulas. If you use a Roth 401(k) and your employer matches your contributions, you get automatic diversification between Roth and traditional accounts. Employer contributions are treated as pre-tax traditional 401(k) assets.
In the future, Roths may offer even greater advantages, should the income tax burden on seniors increase. The higher the income taxes on retirees, the more benefit a Roth account provides; the lower they are, the more a traditional plan makes sense. Of course, the uncertainty about future tax rates is also a good argument for hedging your bets by using a mix of both Roth and traditional accounts.