When you contribute to a 401k or 403b retirement plan, you can choose whether they’re pre-tax contributions or after-tax contributions.
If you choose pre-tax deferrals, your contributions get deducted from your taxable income. You get to pay less taxes the year you contribute, but you’ll have to pay taxes when you withdraw from your account in retirement.
Alternatively, you can choose to make after-tax Roth deferrals into a Roth account. You pay taxes on your income now, but you get to make withdrawals in retirement completely tax-free.
After-tax contributions made to a Roth retirement account using employee deferrals are considered Roth deferrals. You get no immediate tax benefits for Roth deferrals but, since the money’s already been taxed, you get tax-free withdrawals in retirement.
For example, if you contributed a total of $50,000 to your retirement account and it grew to $5 million in retirement:
The most popular types of retirement plans that offer Roth deferrals are corporate 401k plans and solo 401k plans.
A Roth deferral typically refers to employee deferrals. A 401k is an employer sponsored retirement account, while a Roth IRA is an individually owned account.
Therefore, Roth deferrals are classified differently than Roth IRA contributions. When speaking of Roth deferrals, it's typically referring to retirement plan contributions within an employer sponsored retirement account.
Roth accounts are separate accounts in a 401k or 403b retirement plan. Contributions are not excluded from gross income and are taxed based on your tax bracket.
For a 401k, employees can choose to contribute up to 100% of their compensation up to the maximum limit of $20,500 for 2022 ($27,000 if you’re over 50).
Only employee elective deferrals can be contributed to a Roth account. Employer matching contributions cannot be made to a Roth account, and will be treated as pre-tax contributions to a traditional account.
You may want to consider Roth deferrals over traditional pre-tax deferrals if:
Retirement accounts like the solo 401k have tax-free compounding. If you start compounding your money from an early age, not having to pay any taxes on your gains can be a significant tax-savings in your retirement.
You can start taking qualified distributions from your retirement account when you reach the age of 59½. Withdrawals from a Roth account after you reach 59½ years old are excluded from your gross income and aren't subject to taxes.
Withdrawals from Roth deferred contributions are tax-free. No matter how much your retirement account has grown, you'll owe nothing in taxes. The entire nest egg is yours.
Withdrawals made before you turn 59½ years old are considered nonqualified distributions and will get hit with a 10% fee plus income taxes on the amount drawn.
Roth accounts have required minimum distributions (RMD). The IRS forces you to start taking withdrawals from your Roth account at the age of 72. How much you need to take in distributions can be calculated using the RMD table for 2022.
A Roth 401k can be rolled over seamlessly into a Roth IRA, which does not have RMD rules.
Retirement plans like the solo 401k, corporate 401k, and the Roth IRA provide the option to make Roth deferred contributions.
Unlike traditional pre-tax deferrals, you pay taxes on your income now, but can withdraw from your nest egg tax-free in retirement. If you start compounding your money at an early age, and believe you'll be in a higher tax-bracket later in retirement, the tax-savings can be significant.
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