Many people have a traditional 401k through their employer. But what if there was another type of 401k that could offer you even more tax benefits? Meet the Roth 401k. Let’s briefly discuss the Roth 401k and some of the tax advantages and the rules surrounding withdrawals, as it’s essential to understand them before you decide how to fund your retirement plan.
How a Roth 401k Works
Unlike a traditional 401k with pre-tax contributions, contributions to a Roth 401k are made with after-tax contributions. Rather than reducing your taxable income, as with a conventional 401 k, the Roth 401 k dictates you will not receive a tax deduction for your contributions. Still, you won’t have to pay taxes on your withdrawals in retirement.
For example, let’s say you contribute $5,000 to your Roth 401k this year. When you retire and begin taking withdrawals, that $5,000 will come out completely tax-free. In contrast, if you had contributed to a traditional 401k, you would have received a tax deduction for your contribution when you made it. However, when you retire and begin taking withdrawals, those withdrawals would be taxed as ordinary income.
Roth 401 k also differs from a traditional 401 k in how they are funded. With a traditional 401k, your employer makes contributions on your behalf (up to the annual limit). With a Roth 401 k, you are responsible for making all contributions. However, your employer may still offer matching contributions, as they would with a traditional 401k.
Roth 401k Withdrawal Rules
Now that you have a general understanding of how a Roth 401 k works let’s look at the four basic Roth 401 k withdrawal rules so you can make an informed decision about whether or not this savings vehicle is right for you.
Age Limit for Withdrawals
It’s important to understand that, for taxes, the IRS separates your contributions and earnings in a Roth 401 k. While you can make qualified withdrawals anytime, you must be 59 1/2 years old to make tax-free withdrawals on those contributions. From an investing strategy standpoint, keep in mind that if you withdraw any money invested, you will lose out on the potential for future growth.
Penalty for Early Withdrawals
You cannot make non-qualified (early) withdrawals from your Roth 401 k without paying taxes and penalties. If you are younger than 59 1/2 and withdraw your earnings, you will pay income taxes on the money PLUS a 10% early withdrawal penalty. There are some exceptions to this rule, such as using the money for certain medical expenses or education costs. Still, the decision to withdraw earnings early should be weighed very carefully against the financial impact of the tax rate penalties on your investment.
The Five-Year Rule
The five-year rule applies to the principal (the amount you contribute) and the earnings (the investment growth). This means you can’t withdraw your principal or profits without paying the penalty until five years have passed since you opened the account. For example, if you open the account at age 59, you must wait until age 64 for a penalty-free withdrawal. This encourages investors to allow their accounts to grow and also discourages attempts at exploiting an age loophole.
There are some exceptions to the five-year rule. For example, the IRS allows you to use up to $10,000 toward your first home or higher education for yourself or someone else in your family.
Required Minimum Distributions
Required Minimum Distributions (RMDs) are the minimum amount you must withdraw from your retirement account each year once you reach a certain age. For traditional 401ks, that age is 70½.
For Roth 401k, the RMD age is 72. The amount of your RMD is based on your account balance and life expectancy. The IRS provides a handy life expectancy table that you can use to calculate your RMD.
For example, say you’re 70 years old and have $100,000 in your Roth 401k. The IRS life expectancy table shows your life expectancy is 84.2 years. To calculate your RMD, you would divide your account balance by your life expectancy: $100,000 ÷ 84.2 = $1,190.48. This means your RMD for the year would be $1,190.48.
It’s important to note you must take your RMD by December 31 of each year. If you don’t, you will be subject to a 50% penalty on the amount of the RMD you should have withdrawn but didn’t.
The bottom line is this: when it comes to withdrawals from a Roth 401 k, there are a few things you need to keep in mind to ensure everything goes smoothly. First and foremost, ensure you understand the basics of how a Roth 401 k works and how withdrawals generally work. Second, remember you won’t be able to access your money without paying taxes and penalties unless you wait until at least 59 1/2. And finally, be aware of RMDs and withdrawal orders so you can minimize taxes and maximize the growth of your retirement savings.
If you have additional questions or want further assistance determining whether a Roth 401 k suits you and your retirement accounts, contact your Planning Made Simple Coach today. They’ll be able to help ensure you have all the information necessary to make an informed decision.
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