5 Rules That Make the Roth 401(k) Different
Apr 26th 2013 3:17PM
Updated Apr 26th 2013 4:20PM
Just as important as what companies you invest in are the tools you invest with. As more and more employers offer a Roth 401(k), you may have come across this option, and wonder how it differs from the Traditional 401(k). Additionally, you may wonder how a "Roth" 401(k) differs from a Roth IRA. Here are five key facts that will keep your head straight, and maximize your retirement dollars.
1. No income restrictions for Roth 401(k)
Whether you're a millionaire or a pauper, it doesn't matter. You can contribute to a Roth 401(k) no matter what your adjusted growth income (AGI) is. That's completely unlike the Roth IRA - which taxpayers can only contribute to if they have a certain AGI (less than $112,000 for single filers and $178,000 for joint filers in 2013). The only real question to whether you can contribute to a Roth 401(k) is if your employer offers it. And to find that answer, all you need to do is shoot a quick email to human resources.
2. Forced distribution age is in-line with "Traditional" accounts
Roth 401(k)s require contributors to start withdrawing funds at age 70 1/2. The penalty for not doing so is 50% of your minimum distribution. The Traditional 401(k) and Traditional IRA follow similar rules.
Unlike the rest, the Roth IRA has no forced distribution age.
3. "Roth" = "Post-tax"
Similar to the Roth IRA, Roth 401(k) contributions are taxed post-tax. Meanwhile, contributing to Traditional 401(k) and Traditional IRA are pre-tax.
What does that mean? Well, pre-tax means you'll pay tax when you take distributions (withdraw) at retirement. Meanwhile, post-tax means that you pay your tax now, but any future distributions -- hopefully after growing your investments -- are tax-free.
How does that affect you? Well, if you're young, not making much, but expect to earn a greater salary as you near your retirement, then a Roth 401(k) may be the best choice for you. If you expect to be in a lower tax bracket by retirement, then the Traditional 401(k) may be best for you. This may feel like it's going over your head, but luckily, Fool contributor Dan Caplinger has 401(k) tax planning covered.
4. "Roth" = 5 Year "Seasoning" Period
Similar to both IRAs and Traditional 401(k)s, Roth 401(k) contributors can begin distributions at age 59-½ or if you become disabled. However, with the Roth 401(k), you also have to wait five years before you can start your distributions if you want to get its full benefits.
The same is true of those who have contributed to a Roth IRA.
So, if you're nearing your retirement and want to contribute to a Roth 401(k), you may be better off going traditional if you're going to need the money very soon.
5. "Roth" stays a "Roth"
When you leave your employer, you have the option to rollover your 401(k) to an IRA. Now, if you have a Traditional 401(k), rejoice! You have two options: You can roll it over to either a Traditional IRA or a Roth IRA.
On the other hand, contributing to a Roth 401(k) limits your rollover option to just the Roth IRA.
Roth 401(k): Another tool in your retirement kit
While it may be arduous at times, learning all the ins and outs of all the retirement accounts can be fun. Just think: If you minimize your taxes and penalties, you're creating a bigger nest egg. And, if you plan it right, you may get to lie on that Caribbean beach overlooking the crystal ocean a bit sooner.
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Editor's note: In a previous version of this article, the author confused the meanings of "pre-tax" and "post-tax." The Fool and the author regret the error.
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