Are you missing out on this great retirement savings option?
Many workers are unaware that their employers now offer a fantastic retirement savings option that can provide tax free money in retirement. This is called a Roth 401(k) or a Roth 403(b). Learn if this is right for you.
Although Roth 401(k) or 403 (b) accounts became available in 2006, it is only recently that the majority of plan sponsors have offered them.
In 2013, just 58.2% of employers that sponsor a 401(k) plan allowed workers to set aside money in a Roth account. In 2022, 89.1% of employers offered a Roth option, according to a recent poll by the Plan Sponsor Council of America, a trade group.
But Roth uptake by employees remains relatively low.
About 21% of workers made a Roth 401 (k) or 403 (b) contribution in 2022, according to PSCA data. By comparison, 72% saved in a Traditional pre tax account.
Why is a Roth 401(k) or 403(b) so fantastic?
Tax Free Income in Retirement
With a Roth 401(k), your contributions come from money you have already paid tax on. In retirement, every dollar you withdraw will be 100% tax-free. In comparison, each dollar you withdraw from a Traditional 401(k) is taxed as ordinary income (at a rate that can be over 35% for a large 401(k)).
The ability to contribute today, have your money grow for a long time to a much bigger sum, and eventually be able to use that money tax-free is the main reason Suze Orman and I think saving in a Roth 401(k) is the way to go.
No Required Minimum Distribution
Beginning in 2024, if you have a Roth 401(k) and choose to leave the money in that account, when you retire there will be no RMDs (Required Minimum Distributions). That means you can let your money grow and only withdraw it when you need it.
In contrast, with a traditional 401(k), you are required to withdraw money each year after you reach the age of 70-75 (depending on your birthdate and your Required Minimum Distribution Age) and pay taxes on what you have deposited plus the growth at the Ordinary Income Tax Rate.
Withdrawing Money Doesn’t Increase Your Medicare Tax (IRMAA)
Withdrawing money from a Roth 401(k) doesn’t count as ordinary income, so you won’t be required to pay an increased tax for Medicare, called IRMAA. Read my article on IRMAA.
There Are No Income Limits
Unlike a Roth IRA which has income limits on who is allowed to participate, any employee whose company or nonprofit offers a Roth 401(k) or Roth 403(b) can participate. Many people are unaware of this and mistakenly believe that they can’t participate. However, only employees who are currently working can contribute to a Traditional or Roth 401(k) or 403(b). Once you retire, you can no longer contribute.
Tax free money for your heirs
In most cases, heirs can make tax-free withdrawals from a Roth IRA over 10 years. Spouses who inherit Roth IRAs can treat the accounts as their own. That is, there are no deadlines for withdrawals.
Most withdrawals of earnings from an inherited Roth IRA account are also tax-free. However, withdrawals of earnings may be subject to income tax if the Roth account is less than 5-years old at the time of the withdrawal.
Case Study- Roth 401(k) vs Traditional 401 (k)
The best part of saving your money in a Roth 401(k) is you never pay taxes on the growth of your investment. Let me show you what it means, using the example of a woman I’ll call Jenny.
Scenario A: Jenny Deposits $23,000 in a Traditional 401 (k)
Jenny deposits the maximum annual amount of $23,000 in a Traditional 401(k) in 2024 and invests in the S&P 500.
Her taxable income is reduced by $23,000, and since Jenny is in a 24% tax bracket, she saves $5,520 in 2024 taxes.
If her money grows by 9% (average for S&P 500 for 20 years), in 20 years she will have $138,210.49 in her Traditional 401(k) account.
She will be required to withdraw an RMD (Required Minimum Distribution) and pay taxes as ordinary income. She must pay taxes not only on what she has put in, but also on the growth.
Assuming she is still in a 24% tax bracket, she will owe $138,210 x 24% = $33,170.51 in taxes.
After tax money in 20 years: $138,210.49 - $33,170.59 = $105,039.98.
Scenario B: Jenny Deposits $23,000 in a Roth 401(k)
In 2024 Jenny deposits the maximum annual amount of $23,000 in a Roth 401(k) in 2024 and invests it in the S&P 500.
In 2024 , as she is in a 24% tax bracket, she pays $5,520 in taxes on that amount.
If her money grows by 9% (average for S&P 500 for 20 years), in 20 years she will have $138,210.98 in her Roth 401(k) account.
Once she reaches the age of 59-1/2, she can withdraw the money at any time and will not have to pay taxes on it. Any money she takes out won’t increase her Medicare Tax (IRMAA).
After tax money in 20 years: $138,210 - $5,520 = $132,690.49.
If Jenny puts her money in a Roth 401(k), after taxes she will have $132,690.49.
If Jenny puts her money into a Traditional 401 (k), after taxes she will have $105,039.98.
Investing in a Roth 401(k) results in a 26% increase.
Scenario C : Jenny cannot afford the max contribution. She pays the $5520 tax and deposits the after tax $17,480 in a Roth 401(k).
In 2024 , as she is in a 24% tax bracket, she pays $5,520 in taxes on $23,000.
If her money grows by 9% (average for S&P 500 for 20 years), in 20 years she will have $105,039.98 in her Roth 401(k) account.
Once she reaches the age of 59-1/2, she can withdraw the money at any time and will not have to pay taxes on it. Any money she takes out won’t increase her Medicare Tax (IRMAA).
After tax money in 20 years: $105,039.98. The same as Scenario A. However the big difference is that
Jenny is not required to withdraw any money (RMD-Required Minimum Distributions). She can withdraw the money as she needs it or not at all.
Any money she withdraws does not count as ordinary income for any federal programs such as Medicare or Capital Gains Tax.
Jenny can pass this tax free money to her heirs or spouse.
What should you do if you want to participate in a Roth 401(k) or 403 (b)?
Check to See If Your Employer Offers a Roth 401(k) or Roth 403(b)
Most do. I’ve done workshops with many people who were unaware that their employers offered a Roth option. Only after we searched through their benefits website were we able to see that this was so.
Change Your Future Contributions
Although you can’t move the funds from your Traditional 401(k) or 403(b) to a Roth 401(k) or Roth 403(b), you can direct your future contributions to a Roth option.
NOT FINANCIAL ADVICE
The information contained in this article is for informational purposes only and shall not be understood or construed as financial advice. I am not an attorney, accountant or financial advisor, nor am I holding myself out to be.
