The Roth 401k plan was introduced in 2006 and was initially involved with many misunderstandings common for every new introduction. This article provides general insights, which will help you determine whether this type of retirement plan is suitable for your financial needs.
Roth 401k Explained
The introduction of the Roth 401k was pushed by Senator William Roth Jr, where the name of the plan itself comes from. The Roth 401k from tax perspective is similar to the Roth IRA. Thus when opening a Roth 401k account your earnings will be treated regarding taxes the way resources are treated under a Roth IRA.
Generally, under a regular 401k a percentage of your salary is regularly allocated to your 401k account. After you have retired you are capable of retrieving the accumulated sum. The retrieved distributions are subject to the same taxes as a regular income.
The difference between a regular and a Roth 401k is that the employer pays the required taxes up front in order to avoid tax deductions from their current salary. The main difference is in the time period during which you choose to be subject to taxes - on your entrance of the 401k plan or on your exit.
Roth 401k Plan and Normal 401k Plan Comparison
Keep in mind that your employer may not have included the Roth 401k plan in your portfolio of options since it is a novelty that many employers are still confused of. Your choice between the two should generally depend on your current and expected financial situation.
You should choose a Roth 401k plan whenever:
- The tax bracket you are in is a lower one
You should choose Roth 401k plan whenever the tax rate you are currently subject to is lower than the one you expect to incur when you retire. In this way you will benefit from the lower tax rate by greatly reducing your financial burden.
- A trend of continual tax rate increase is observed
- You are making your first steps as an investor
Remember that the more time you spend with a particular retirement plan, the greater sums will be accumulated due to compounding.
- You have high salary and thus are blocked from Roth IRA.
Roth IRAs have several tax limitations that are not observed in Roth 401k.
- You seek tax diversification
Since you are charged up front taxes in Roth 401k plans, you will gain the opportunity of withdrawing money from the account in accordance with your specific financial needs during retirement years.
- You have included mutual funds that make you win high returns
Facts to beware of
If you have decided to invest in a Roth 401k five years before your retirement date, you may be subject to taxes. This is due to the unqualified distributions that will occur. Roth 401k doesn't provide the opportunity of matching, since by law such contributions are required to go to the traditional 401k plan.
Roth 401k Unclear Future
The legitimacy of Roth 401k and Roth IRAs expire in 2010, when the congress should vote for their renewal. If their existence is not confirmed, you will be deprived of your Roth 401k or Roth IRA and the accumulated sums will be transferred to another type of plan. You will not lose your money! They will be reallocated to the conventional retirement plans. When experiencing such transference, the money in your account will not be charged any taxes.
The good news is that the contribution limits to Roth 401k plans are the same as the ones of the conventional 401k plan.
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