Investing in a Roth 401(k): Pay Taxes Now, Reap the Benefits Later

Roth 401k - Pinnacle Capital Mortgage

When you’re planning for retirement, all your account options can get confusing quickly. You’ll want to consider factors such as your age, tax bracket, current financial situation and expected future earnings to choose the best plan for your portfolio.

A Roth 401(k) is a relatively recent type of employer-sponsored retirement plan that blends the benefits of both a traditional 401(k) and a Roth IRA. In many cases, this makes the Roth 401(k) the most fruitful retirement savings option, particularly for younger workers.

How a Roth 401(k) Works

Post-Tax Contribution

Like with a Roth IRA, Roth 401(k) contributions are made with post-tax money. This is the biggest differentiator between Roth and traditional 401(k) plans – with a traditional 401(k), you contribute pre-tax money and lower your taxable income.

By paying taxes on your contribution now, you ensure that you receive your entire nest egg when you retire, regardless of what tax bracket you’re in later in life.

Contribution Limits

For 2018, you can contribute up to $18,500 a year to your Roth 401(k), or $24,500 if you’re 50 or older. Keep in mind that this contribution limit is a combined cap that applies to your traditional and Roth 401(k) accounts. Even with that stipulation, this is a much larger amount than you can contribute to a Roth IRA – $5,500 annually.

An additional benefit is that there’s no income limit for a Roth 401(k) like there is with a Roth IRA. This makes a Roth 401(k) a viable option for those making more than $120,000 to $135,000 in modified adjusted gross income (MAGI).

Split Contributions

If your employer offers both plans, you can split contributions between a traditional and Roth 401(k). This may be the best option for you if you:

  • Aren’t sure which tax bracket you’ll be in when you retire
  • Need more take-home pay in the short term
  • Want to diversify your retirement savings and reap the benefits of both accounts

Roth conversions are also an option if you want to diversify your investments after the fact.

Distribution Rules

Distribution rules are similar between traditional and Roth 401(k) plans. Qualified withdrawals can begin at age 59 1/2 or upon the death or disability of the account holder.

There is one major caveat with Roth 401(k) plans – you must have had the account for at least five years. That means if you created your account at age 57, you’d have to wait until age 62 to make qualified withdrawals.

Unqualified Withdrawals

If you need money sooner than that, you have the option to make an unqualified withdrawal. The penalty is that you will have to pay taxes on any account earnings, but not on your contributions, as you’ve already paid tax on that portion.

You can also take a loan from your own account of up to half the balance, not exceeding $50,000. You must repay the loan within five years.

Required Minimum Distributions

Both traditional and Roth 401(k) plans require minimum distributions at age 70 1/2 or later, depending on when you retire from the employer sponsoring the plan. This can be a pain for those hoping to hold on to their nest egg for a little longer.

Fortunately, there is a way to get around this. By rolling the Roth 401(k) into a Roth IRA, you circumvent the required minimum distribution so your money is protected until your death.

Employer Match

Many employers match Roth 401(k) contributions, which means free money for you. Matching contributions are made into a traditional 401(k) account, though, so the money is taxed upon withdrawal.

Who Should Invest in a Roth 401(k)

The truth is, anyone can benefit from a Roth 401(k), but this plan can be especially lucrative for young workers in a lower tax bracket who expect an increase in earnings by the time they retire. By pinching pennies and contributing to a Roth 401(k) plan now, they can save a significant amount in taxes and let their nest egg grow tax-free throughout their life.

Choose the Right Home Loan With Pinnacle Capital Mortgage

Retirement plans are just one piece of the financial planning puzzle. When it comes time to retire, a home can be an extremely valuable asset and a quick source of extra funds.

At Pinnacle Capital Mortgage, our loan officers can help you navigate your home loan options so you can set yourself up for stability later in life. With the right mortgage and repayment plan, you can build equity and own your home outright by the time you retire.

You may even want to take a loan from your Roth 401(k) to put toward the down payment of a new home. Putting a great amount toward your down payment may help you obtain a shorter term and decrease the total interest you will accrue – plus, you may be able to avoid having to pay for private mortgage insurance (PMI).

For more information about your home loan options, call Pinnacle Capital Mortgage today!

Sources

https://www.nerdwallet.com/blog/investing/roth-401k/
https://www.daveramsey.com/blog/traditional-401k-vs-roth-401k
https://investor.vanguard.com/ira/roth-ira-income-limits
https://money.cnn.com/2018/05/10/pf/401k-vs-roth-retirement-accounts/index.html
https://www.investopedia.com/ask/answers/101314/what-are-roth-401k-withdrawal-rules.asp
https://www.kiplinger.com/article/retirement/T001-C001-S003-delaying-required-minimum-distributions.html
https://www.irs.gov/retirement-plans/retirement-plans-faqs-regarding-required-minimum-distributions
https://www.investopedia.com/ask/answers/102714/are-roth-401k-plans-matched-employers.asp