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What is a 'Roth 401(k)'

A Roth 401(k) is an employer-sponsored investment savings account that is funded with post-tax money up to the plan's contribution limit. This type of investment account is well-suited to people who think they will be in a higher tax bracket in retirement than they are now. The traditional 401(k) plan is funded with pretax money, which results in a taxes on future withdrawals.

BREAKING DOWN 'Roth 401(k)'

Employee contributions are made using after-tax dollars with no income limitations to participate. A Roth 401(k) is subject to contribution limits based on the individual’s age. For example, the contribution limit for individuals in 2018 is $18,500 per year. Individuals 50 and older can contribute an additional $6,000 in 2018  as a catch-up contribution, according to the IRS. Withdrawals of any contributions and earnings are not taxed as long as the withdrawal is a qualified distribution. Distributions are required for individuals at least 70 ½ years old unless the individual is still employed and not a 5 percent owner of the business.

Qualified Distribution of a Roth 401(k)

Contributions and earnings in a 401(k) are eligible to be withdrawn without an income tax assessment as long as certain criteria are met. First, the Roth 401(k) account must have been held for at least five years. Additionally, the withdrawal must have occurred on the account of a disability, on or after the death of an account owner, or when an account holder reaches at least 59 ½ years old.

Roth 401(k) Vs. Traditional 401(k)

The main difference between a Roth 401(k) and a traditional 401(k) relates to the taxation of funding and distributions.

When a traditional 401(k) is funded, the account holder the contribution is deducted from the employee's pre-tax income. Alternatively, contributions made to a Roth 401(k) are made after taxes are already taken out.

When a distribution is made from a traditional 401(k), the account holder is subject to taxation on the contributions and its earnings. Alternatively, the account holder is not subject to any taxation from Roth 401(k) distributions so long as they are qualified.

A Roth 401(k) Strategy

The benefits of a Roth 401(k) have the most impact on individuals currently in low tax brackets who anticipate moving into higher tax brackets in the future. This is because contributions are taxed now at a lower tax rate and distributions are tax-free when the individual is in a higher tax bracket. For this reason, a Roth 401(k) is not advised for individuals who expect to drop tax brackets, such as individuals close to retirement and expect a drop in income.

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