Should you be contributing to your Roth 401(k)? The short answer is yes because anything with the word Roth in front of it is truly tax-free.
What does it mean to be truly tax-free? Roth 401(k)’s pass both litmus tests for what makes something tax-free.
If you’re younger than 50, you can put in $19,500 each year, and if you’re over the age of 50, you can catch up a bit with an additional $6,500. You can also still get the match when contributing to your Roth 401(k). Your company will put those dollars into your tax-deferred bucket.
It’s okay to have some money in your tax-deferred bucket because the IRS is going to force you to take money out of that bucket at age 72, but you will be able receive up to a certain amount of money tax-free because of your standard deduction.
In many cases, this can mean that you can put pre-tax dollars into your tax-deferred bucket and get a deduction on the front end. It will grow tax-deferred, and you'll be able to take it out tax-free.
It’s ideal to have multiple streams of tax-free income and Roth 401(k)’s fit into the typical strategy that David recommends to his clients.
There is a big difference between Roth 401(k)’s and Roth IRA’s. With a Roth 401(k), the IRS will force you to take the required minimum distributions at age 72 for the same reason they force your beneficiaries to withdraw money from an inherited Roth IRA. They want that money going back into circulation so it can be taxed again.
The strategy around this is to roll Roth IRA dollars into a Roth 401(k) account, but you have to be aware of the different rules around the Roth 401(k) first.
Roth IRA’s have a five-year holding period, similar to Roth 401(k)’s, but they function differently. If you don’t currently have a Roth IRA, open up one now and start your five-year clock.
Keep in mind that any money rolled from a Roth 401(k) into a Roth IRA will still have to contend with the ten-year window your beneficiaries will have to spend down the account when they inherit the money.
If you only have enough money to fund your Roth 401(k) up to $26,000 per year but that doesn’t leave anything left over for the LIRP, what should you do? You need both, so a good strategy is to put enough into your Roth 401(k) to get the maximum match and the rest into your LIRP.
Don’t put yourself into a position where it’s either/or. Instead, put yourself into a position where you can get the best of both buckets.
You should be doing a Roth 401(k), so reach out to your human resources department to add one. Not only will you benefit, but your fellow employees will as well.