A Roth 401(k) is an employer-sponsored retirement savings account that is deducted from an employee’s paycheck each pay period and funded with after-tax dollars. Because taxes are paid before the money goes into the account, withdrawals from a Roth 401(k), including capital gains and account growth, are tax free in retirement.
The Internal Revenue Service (IRS) defines how much can be contributed to an account each year based on age. You can find information regarding contribution limits, withdrawal rules, and required distributions through the IRS website.
While a Roth 401(k) is beneficial, there are some factors to consider when deciding if the plan is right for you. Read on to learn about the pros and cons that come with a Roth 401(k).
Pros and Cons of a Roth 401(k)
Saving for retirement is a critical component of every financial foundation, but different types of accounts should always be considered. For a Roth 401(k) specifically, the pros outweigh the cons, as noted below.
The pros of a Roth 401(k) Plan include:
- As an employer-sponsored account, employees can utilize 401(k) matching, which includes the employer matching a percentage or flat dollar amount of the employee’s salary into the 401(k) account each year. This means that you can double your contributions each year up to a predetermined amount, helping you establish and maintain a solid nest egg for retirement.
- As a tax-advantaged account, a Roth 401(k) benefits employees that are currently in lower tax brackets, but expect to move into a higher bracket as they get closer to retirement. This means that the funds are taxed at a lower income level and will not be penalized later in retirement when they are withdrawn, as long as the participant owned the account for over five years and is at least 59½ years old. If you fail to meet those requirements, you may face a 10% penalty when withdrawing funds.
- Because Roth 401(k) plans are tax-advantaged, they also fall into tax-free distribution. This means that regardless of how much the account grows over the years, the funds are exempt from additional taxation in retirement.
- As an employer-sponsored account, employees have the benefit of low-effort investing. Many companies have pre-determined or limited investment options, making the account easy and stress-free for participants.
- If you terminate your employment, you can easily transfer your Roth 401(k) into a Roth IRA when you leave.
Cons for a Roth 401(k):
- If a participant needs to withdraw funds from a Roth 401(k) before the IRS’s approved retirement age, then the participant will face an early withdrawal penalty, therefore losing funds.
- Roth 401(k) plans have required minimum distributions. This means that participants aged 70½ or older are required to withdraw funds annually from the account.
- Because the plan is employer-sponsored, participants using a Roth 401(k) have limited investment options. While this is an easy and stress-free option for many, others may prefer more control over the account and where the funds are being invested.
Why You Should Choose a Roth 401(k)
While there are pros and cons to every type of retirement account, a Roth 401(k) is a solid option for many participants. Not only is the account easy and stress-free to manage, but with options like employer matching, the account has potential to grow exponentially over the course of your career.
Roth 401(k) plans also provide participants financial freedom in retirement due to funds being taxed upon deposit. Therefore, the total you see in your account is the total you will have available to you in retirement, unless you find yourself in a position to withdraw funds early.
If you’re unsure if a Roth 401(k) is the right retirement plan for you, contact a financial advisor. Together, they can help you decide which account is appropriate for you based on your income, flexibility, and retirement goals.
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