How To Maximize Retirement Savings With Roth 401(k)

“It has been steadily increasing,” said Hattie Greenan, director of research at the Plan Sponsor Council of America (PSCA). She was referring to the growth of Roth 401(k) accounts in recent years.

To provide more context, PSCA surveyed 550 employers across the United States. The report revealed that almost 28% of workers made Roth 401(k) contributions in 2021, up from 18% three years prior.

Experts believe that favorable policies and public awareness are behind this steady growth. For example, articles on how tech moguls like Peter Thiel accumulated over $5 billion from Roth retirement accounts certainly make more taxpayers interested.

However, Roth 401(k) has a lot of intricacies. This article covers the ins and outs of a Roth 401(k) to help you understand Roth 401(k) better.

What Is a Roth 401(k)?

A Roth 401(k) is an employer-sponsored retirement account. As the name suggests, it combines features of both a traditional 401(k) and a Roth IRA. What separates Roth 401(k) from traditional 401(k) is how contributions are taxed: You pay taxes on your Roth 401(k) contributions based on your current income tax bracket, but that relieves you from paying any taxes when you withdraw your retirement savings.

As mentioned, Roth 401(k) has grown in popularity among both employers and taxpayers. Almost 88% of employers offer Roth saving options to employees these days. Roth accounts are gaining traction among younger taxpayers, who are heavily investing in tax savings.

Basics of Roth 401(k)

To maximize your retirement savings, you must have a good grasp of the basics of Roth 401(k). Without further ado, let’s get into it.

Contribution limit

A Roth 401(k) contribution limit depends on an individual’s age. Usually, if you are 50 or older, you get to contribute more via a catch-up contribution on top of your regular contribution limit. Every year, the IRS adjusts this limit based on inflation and other factors.

For 2022, anyone under the age of 50 can contribute up to $20,500. And 50+ individuals can go up to $27000 ($20,500+ $65,00 catch contribution). For 2023, the contribution limit touches $22,500, and the catch-up contribution increases to $7500.

Withdrawals rules

Roth 401(k)s are popular because of tax-free withdrawals. However, this tax-free status will not apply if you don’t meet the following criteria:

  • The Roth 401(k) account must have been held for 5 years minimum.
  • The owner can withdraw after the age of 59.5 years. However, withdrawal after the death of the owner is also tax-free.
  • In the case of disability, Roth withdrawals are tax-free, too.

And what if due to an emergency, you are forced to take a distribution from your Roth 401(k) account?

In such a case, the IRS would consider that distribution as a non-qualified distribution. You need to add the income portion of that non-qualified distribution into your gross income and might need to pay taxes on the sum.

Speaking of distributions, you are required to take the required minimum distribution (RMD) when you reach the age of 73. You are free to take bigger distributions though.

However, if you miss taking RMD (or less than your RMD amount), you are asking for trouble. The IRS will slap a penalty equal to 25% of the missed withdrawal’s value. You can reduce this penalty to 10%, provided you withdraw the remaining amount of RMD and submit a corrected tax return within the due date.

Here is the good news: From 2024 onwards, all this RMD-related stuff will not matter anymore. Recent SECURE ACT 2.0 has made employer-sponsored Roth retirement accounts free from mandatory RMD requirements.

When you should go for Roth 401(k)

Choosing a Roth 401(k) account over a traditional pre-tax 401(k) plan makes sense when you are young. Some experts like Ted Jenkin (CEO of oXYGEN Financial) even advise anyone in the 24% or less income tax bracket to choose either or both Roth 401(k) or Roth IRA.

When younger people enter the workforce, they usually stay below the 24% income tax bracket. Therefore, in the long run, they can accumulate large tax-free savings (and free gains) while paying relatively lower taxes upfront.

Roth savings can also save you money on Medicare Part B premiums. These premiums are based on your taxable income. Since Roth withdrawals are not taxable, if you strategically withdraw money from your Roth accounts, you can avoid increasing your taxable income and paying higher Medicare Part B premiums.

It is important to note that your actual results may vary. Consult a financial advisor to determine how Roth savings can best be used.

Strategies To Maximize Your Return From Your Roth 401(k)

We have already covered Roth 401(k) 101. Here are some ways to maximize your nest egg.

Start early

The sooner you start, the sooner compound interest starts showing its magic. That’s investment 101.

It applies to your Roth 401(k) too. When you start contributing early, your contributions get more time to grow, resulting in a bigger pay day when you withdraw years later.

Also, in your early career, your income tends to be on the lower side. Therefore, you pay a much lower tax on your Roth 401(k) contributions and get to withdraw tax-free (if you are qualified) later.

On the other hand, you don’t get such opportunities with a traditional 401(k). You pay income tax based on your income (which is usually higher) later in life when you would probably be in a higher marginal tax bracket.

Consider asset location

By the time of retirement, you might find yourself in a completely different financial situation than what you have anticipated. Yes, it’s more likely you would be in a better financial position. However, some adverse events (bad economy, job loss, bankruptcy) can push you towards financial hardship.

To minimize negative financial impacts, you want to split your retirement investment between a Roth 401(k) and a traditional 401(k). Why? Because with this arrangement, you pay half of the taxes now (lower tax) and the remaining after you retire, which could be higher or lower.

Also, your asset allocation and diversification are equally important. Jeffery Levine (CPA and CEO of Blueprint Wealth Alliance) suggests:

“You’d probably want that Roth to be 100% in equities and allocate all your bonds to the traditional account.”

Stock options have massive growth potential, and you want those gains tax-free. Therefore, Jeffery’s words make total sense.

On the other hand, gains from bonds tend to be moderate. You can safely assume your taxes on retirement earnings would not be extremely high if you allocate bonds to your traditional 401(k) account. Your employer matches all or some of your 401(k) contributions. That is essentially free extra money.

Know your limits

As we mentioned before, the IRS does have some limits on how much you can contribute to your Roth 401(k) annually. In 2023, it is $22,500 for anyone under the age of 50. For citizens 50 or over, an additional catch-up contribution of $7,500 is applicable ($30,000 in total).

Even if you split your contribution between a traditional 401(k) and a Roth 401(k), your limit remains the same.

However, when you take into account your employer contribution, numbers change quite a bit. According to IRS, the additional contribution made by your employer must not exceed the lesser of:

  • 100% of your compensation.
  • $66,000 ($73,500 including catch-up contribution) in 2023 and $61,000 ($67,500 including catch-up contribution)

Note: If you have a side business along with your primary job, you want to get a Roth solo 401(k).

Yes, you cannot contribute more than $22,500 to any Roth 401(k) account, be it an employer-sponsored one or a Roth Solo 401(k). However, if you made enough from your business, you are eligible to make a nonelective contribution of up to $66,000.

Your payment to Roth 401(k) from your salary doesn’t have any effect on this $66,000 limit.

Fund a Roth IRA

If you are already contributing to a designated Roth 401(k), you want to get a Roth IRA account, too (as long as you stay within income limits on Roth IRA).

Why?

Because Roth IRA covers some of the downsides of Roth 401(k):

  • A Roth IRA can exist without any required minimum distribution (RMD) while the owner is alive. If the owner passes away, their spouse (listed as a beneficiary) can skip taking any required minimum distribution or paying any taxes. On the other hand, Roth 401(k) comes with a mandatory required distribution at the age of 73.

    Note: Recently, SECURE Act 2.0 has freed Roth 401(k) from any RMD 2024 onwards.

  • In Roth 401(k), investment options are somewhat limited. You can choose only from whatever investment options your employer’s plan has to offer. As you can expect, that may not be the best for maximizing your retirement savings.

    A Roth IRA is way more flexible in this regard. As an IRA investor, you can choose from a larger investment option pool, including stocks, bonds, and funds.

    You can maximize the match from your employer and then pour your extra investment funds into your Roth IRA account to reallocate assets for maximum growth and tax-free withdrawal.

  • Since your employer isn’t involved, you can keep saving with the same Roth IRA even if you change jobs.

Please note you are eligible for a Roth IRA only if your modified adjusted gross income is in the range given below.

Filing Status 2023 Modified Adjusted Gross Income Contribution Limit
Single/head of the household Less than $138,000 Full contribution
$138,000 to $152,999 Reduced
Over $153,000 Not eligible
Married filing jointly Less than $218,000 Full contribution
$218,000- $227,999 Reduced
Over $228,000 Not eligible
Married filing separately Less than $10,000 Reduced
Over $10,000 Not eligible

In 2023, the contribution limit is up to $6,500 if you are under the age of 50. Individuals aged 50 and above may still qualify for the additional $1,000 catch-up contribution.

Stay until you are vested

According to IRS rules, your employer matches your contribution to your Roth 401(k) account. Whatever amount your employer matches is essentially free retirement money.

However, there is a fine print: if you leave your job before becoming fully vested, you may lose a part of the total employer contribution. Many companies require a specific number of years of service before they let you keep their contributions.

Some of these companies have a “cliff” vesting schedule. You can't take any contribution unless you stay with them for at least one to three years. Others use a graded vesting schedule which allows employees to take a portion of employer 401(k) match based on years of service. But to qualify for 100% of 401(k) benefits, you have to spend at least 5-6 years on the same job.

Therefore, you should take this into account while making any strategic career change. Here is what Todd Sensing ( Certified financial planner and Founder of Familyvest) wants you to remember:

"If you are in a miserable employment situation or have a life-changing opportunity to go somewhere else, maybe you have to sacrifice the unvested portion.”

Don’t forget about it

Let’s be honest; it’s easy to forget about your Roth 401(k). Contributions often get auto-deducted from the salary, and many forget to check how much balance they have. Most likely, they can't even remember exactly what stocks or bonds they have been investing in for years.

Without a doubt, it’s not the smart thing to do. Of course, a retirement account like Roth 401(k) should not be subject to constant change. But that shouldn’t stop you from checking on it once or twice yearly.

During your annual Roth 401(k) review, you want to do the following:

  • Review your statements properly.
  • Make sure you understand your investment fees and plan fees associated with Roth 401(k).
  • If certain investments are underperforming, you might want to change them.
  • You want to reallocate your assets if you invested too much money in one category (stock, bond, or funds).

If you don’t know what you are doing, it’s better to have the unbiased opinion of a qualified financial expert.

In conclusion, Roth 401(k) offers tax-free retirement withdrawals in exchange for paying taxes on contributions. It can be extremely lucrative for younger people in lower-income tax brackets. However, to receive a big withdrawal, you have to start early, diversify your accounts and investments, plan well, and wait patiently.

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