Wednesday, May 4, 2011

Understanding Roth 401(k) and Roth IRA

Roth 401(k) is another after-tax contribution to 401(k), which has earning tax-free advantage with qualified distributions.Qualified distribution – two conditions must be met:

  1. distribution taken after five-year period, and
  2. distribution taken after age 59½, or due to death or disability
Roth 401(k) contributes to IRS limit (e.g. for year 2011)
Pretax contributions + Roth 401(k) contributions ≤  $16,500 (under 50)
                                                                            $22,000 (age 50+)

Roth 401(k) has Required Minimum Distribution
Required Minimum Distributions (RMDs) generally are minimum amounts that a retirement plan account owner must withdraw annually starting with the year that he or she reaches 70 ½ years of age or, if later, the year in which he or she retires. However, if the retirement plan account is an IRA or the account owner is a 5% owner of the business sponsoring the retirement plan, the RMDs must begin once the account holder is age 70 ½, regardless of whether he or she is retired. [See for Retirement Plans FAQs regarding Required Minimum Distributions]

Besides Roth 401(k), we have other contributions like Pre-tax, After-tax, matching contributions and rollover. The key difference among them is about tax strategy on contributions and earnings.

  • Pretax contributions: taxed on the way out (for both contributions and earnings)
  • Roth 401(k) contributions: taxed on the way in (for contributions, tax-free for earnings for qualified distributions)
  • After-tax contributions: contributions taxed on the way in, earnings taxed on the way out
  • Matching contributions: similar to pretax contributions, cannot be Roth 401(k) contributions though company matching is for both pretax and Roth 401(k)

Roth IRA:
  • After-tax contributions
  • Has certain income limit (higher income cannot open Roth IRA)
  • Has IRS limit ($5,000 if age 49 or younger, $6,000 if age 50 or older)
  • Has no Required Minimum Distribution
  • Cannot be rolled into Roth 401(k)
  • Tax-free for earnings for qualified distributions - same as Roth 401(k)
    • distribution taken after five-year period, and
    • distribution taken after age 59½, or due to death or disability 
Note: There is a tax advantage for beneficiary if convert 401K/IRA to Roth IRA before die.

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