Meet the Roths: 401(k) and Traditional

Sticky Notes with Roth, IRA, and 401(k)

Congratulations—it’s a ROTH! Relatively new on the scene of employer-sponsored retirement benefits, the Roth 401(k) is the tax-free cousin of the Traditional 401(k). You might already be familiar with the Roth 401(k)’s big sister, the Roth IRA. Both accumulate after-tax deposits that can grow and be distributed tax-free when certain criteria are met. But, the two siblings have some important differences that we’ll address below. Be careful not to confuse them, even though they look alike!

The Roth 401(k) is more common than ever because employers realize how attractive tax-free growth is as part of benefits packages. Still, the Roth 401(k)—like its more Traditional cousin—has numerous rules that impact ultimate tax treatment. As an investor (yes, you!), understanding these rules is critical for optimizing your tax position in retirement.

Tax-Free? Really?

Mostly, yes! Distributions from your Roth 401(k) qualify for tax- and penalty-free treatment, for the most part. As an investor, make sure that the following apply to you before requesting Roth 401(k) withdrawals:

• You are 59-1/2 years old, OR you have become disabled or deceased (very impressed that you’re reading this if you fall into the last category) AND

• You have held the account for at least five tax years.

If you make a withdrawal outside of these circumstances, it will be characterized as non-qualified and could be subject to income taxes and possibly penalties. In this way, a Roth 401(k) is the same as a Roth IRA.

Rollover Options

Rollover options for a Roth 401(k) are like those for its cousin, the Traditional IRA. If you leave a company through which you had a Roth 401(k), you can:

  • Maintain the 401(k) with your (now) previous employer
  • Rollover the 401(k) balance into another employer-sponsored retirement plan that allows for rollovers into a Roth 401(k) plan
  • Rollover the account into a Roth IRA (aka Older Sis)
  • Cash out the account value (usually not the best plan, by the way!)

The first three options are generally free of tax consequences. The fourth, however, can stick you with a big tax/penalty bill if you don’t meet the qualified distribution requirements laid out above.

Minimum Distributions

The minimum distribution requirements for both Roth 401(k) and traditional 401(k) plans are similar and begin when participants reach age 72 (the age was increased from 70-1/2 on January 1, 2020. Account holders who turned 70-1/2 prior to that date are subject to the old rules).

However, Roth IRAs do not require account holders to take lifetime distributions. Here we see a big difference between the Roth Sisters. If you’d rather not be bound by IRS constraints on when to take money from your account, a Roth 401(k) to Roth IRA rollover may appeal to you.

Other Considerations

For both Sisters, you owe taxes on money you put into a Roth, just like you would if the money had gone straight to your bank account instead. If you expect higher tax rates in the future OR if you expect substantial account growth, the delayed-tax-gratification strategy might be attractive. Here’s what I mean:

Example 1: Working today, in the 12% tax bracket, you contribute $10,000 to a Roth 401(k). You expect to be in the 24% tax bracket when you retire.

Simple math favors paying 12% on $10,000 worth of income today in exchange for paying at the 24% rate when you withdraw in retirement—$1,200 versus $2,400—pretty straightforward.

But what if you expect to be in a lower bracket in retirement? A Roth 401(k) may still provide an advantage. Look at this:

Example 2: Age 45 and working today in the 35% bracket. You expect to retire at 65 in the 22% bracket. Where do you put $10,000 worth of 401(k) savings?

A $10,000 contribution, when grown at an 8% average return per year, will be worth $46,000 in 20 years. With a Roth, you pay $3,500 in taxes against your original $10,000 contribution; then $46,000 is yours tax-free when you retire. Reversing the situation, the $46,000 would generate a $10,120 tax liability against your lower 22% rate in retirement. Don’t let a lower tax bracket mislead you into assuming your total dollar outlay will be smaller.

Despite being a high earner, we now see how either of the Roth Sisters can be a strategic part of your retirement plan. But the Roth 401(k) is even more attractive for high earners than her IRA sister. Why? Income does not exclude participants from making Roth 401(k) contributions. However, Roth IRA eligibility phases out at a modified adjusted gross income of $124,000 for single taxpayers and $196,000 for married individuals filing jointly.

Furthermore, Roth 401(k)s could make the elusive and rarely used mega-backdoor Roth more accessible than a plan with only a Traditional 401(k) available (caveat: the mega-backdoor is still elusive and rarely used, even with a Roth 401(k). Talk to your advisor to see if you could be eligible.) Simply put, the Roth IRA is not available beyond a certain income threshold, while the Roth 401(k) remains available.

Bottom Line: Roth 401(k)s are part of the Retirement Vehicle family you already know and love, and they share many of the same characteristics. But don’t let their differences intimidate you—a Roth 401(k) could be a great fit for your portfolio of retirement plans.

Do you want to know more? Give us a call, and we’ll chat!

***Traditional IRA account owners have considerations to make before performing a Roth IRA conversion. These primarily include income tax consequences on the converted amount in the year of conversion, withdrawal limitations from a Roth IRA, and income limitations for future contributions to a Roth IRA. In addition, if you are required to take a required minimum distribution (RMD) in the year you convert, you must do so before converting to a Roth IRA.

A Roth IRA offers tax deferral on any earnings in the account. Qualified withdrawals of earnings from the account are tax-free. Withdrawals of earnings prior to age 59 ½ or prior to the account being opened for 5 years, whichever is later, may result in a 10% IRS penalty tax. Limitations and restrictions may apply.

Benchmark Wealth Management
5855 Ridge Bend Road
Memphis, TN 38120

Securities and advisory services offered through LPL Financial, a Registered Investment Advisor, Member FINRA/SIPIC.

The opinions voiced in this material are for general information only and are not intended to provide
specific advice or recommendations for any individual. There is no assurance that the views or
strategies discussed are suitable for all investors or will yield positive outcomes.
Investing involves risk including possible loss of principal.

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