The Magic of using a Roth 401K
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Here are the upsides to having a Roth 401(k):
- The Roth 401(k) contribution limits are higher compared to the Roth IRA. This allows individuals to contribute more money on an after-tax basis. The Limit for 2024 is $23,000 for the combined contribution on your traditional 401(k) + Roth 401(k). On a Roth IRA, the contribution limit is only $7000. If you contribute $23,000 to your Roth 401(k) for 2024, you will not be able to contribute any more into your traditional 401(k) as you have maxed out the limit for the year.
- Serves as a great estate-planning. Inheriting a Roth 401(k) can be a tax-efficient way to pass on wealth, because withdrawals are tax-free. Heirs may be able to continue the tax-free growth by taking required minimum distributions based on their life expectancy.
- Thanks to the Secure Act 2.0, starting 2024, you (as the account owner) no longer have Required Minimum Distributions (RMDs) on your Roth 401(k). You can keep your money there growing tax-free for as long as you wish.
- Eligible for employer matching - if that is offered at your place of employment. Previously, the employer match for your Roth 401(k) contribution goes into the traditional 401(k). However, with the Secure Act 2.0, employers can, if they really want to, place the matching into the Roth 401(k) directly. Honestly, that change requires more work for the employer and you're lucky if they actually do that for you.
- And of course, our favorite, tax-free withdrawals. You pay ZERO taxes on your withdrawals including all the gains from your investments over the many many years you've been contributing into your Roth 401(k) account. It's a complete win in my book.
Like everything in life, here are the downsides of using a Roth 401(k):
- You do not get a tax break on the front end. This means that your take home pay may be smaller than if you invest in a traditional 401(k).
- You have to share the $23,000 maximum contribution amount between your traditional 401(k) and your Roth 401(k) as I have mentioned above.
- Contributing to a Roth 401(k) means you are betting that your future tax rate will be higher than your current rate.
- Tax laws change over the years, and we do not know if tax-free withdrawals will remain in the future.
- The absence of a tax break during contribution means that high income earners cannot lower their taxable income.
Carefully evaluate your personal financial situation, tax considerations, and retirement goals when deciding whether to add a Roth 401(k) into your investment portfolio. It is best to consult with an unbiased fee-only fiduciary financial advisor who can provide a tailored plan based on your specific circumstances.
I hope this clarifies the significance of a Roth 401(k). I wrote this article because this became a recent offering in our company and I thought that it may help a lot of people with their quest for financial freedom. Questions are welcomed in the comments section.
-Pam
