A 401( k) is a type of employee-sponsored profit-sharing plan that allows your contributions to grow tax-free. Initially established to shield income from taxes until money is withdrawn, a newer version called a Roth 401(k) is funded by after-tax income. Withdrawals are tax-free. Many Roth 401(k)s allow all of an employee’s post-tax salary to be automatically deposited, subject to contribution limits. Optionally, an employer can contribute to an employee’s Roth 401(k), but only with pre-tax dollars that must be accounted for separately.
For 2013, you can contribute the lesser of your post-tax income or $17,000 into a Roth 401(k). If you're at least 50 years old, the annual limit rises to $23,000, but may be reduced at your employer’s discretion. You have the option of splitting your total eligible contributions between pre-tax and Roth 401(k) plans. If you have both a pre-tax and Roth 401(k) plan, the total combination individual plus employer contribution limit is the lower of your annual compensation or $51,000. Employers can't contribute more than 25 percent of employer compensation to an employee’s 401(k) accounts. One major benefit, for some: There are no income caps that limit contributions to a Roth 401(k), unlike a Roth IRA.
As of 2013, you're permitted to convert your traditional 401(k) into a Roth 401(k) without waiting until you reach age 59 ½. You must pay income tax on the amount you convert. Lower-bracket taxpayers pay the least taxes on a conversion, which might motivate them to convert if they feel they'll later occupy higher brackets. The conversion is permanent; you can't reconvert to a traditional 401(k) once you’ve gone Roth.
Roth 401(k) Features
Roth 401(k) distributions can begin at age 59 ½ as long as the account has been open for at least five years. Exceptions for disability are available. Unlike a Roth IRA, a Roth 401(k) requires the employee to begin taking distributions at age 70 ½ unless the employee is still on the job and is not a company owner. Only an employer of sole proprietor can set up a 401(k) plan.
You may borrow the lesser of 50 percent or $50,000 from your Roth 401(k) account balance. Early withdrawal while working for the same employer is punished with a 10 percent penalty on the taxable portion of your distribution and you’ll have to pay taxes on the earnings. At termination, you can roll a Roth 401(k) into a Roth IRA. You always have the right to roll over your Roth 401(k) to that of another employer. Your Roth 401(k) is protected from the greedy fingers of bankruptcy lawyers and creditors, unless the creditor is the Internal Revenue Service.
- IRAs, 401(k)s & Other Retirement Plans: Taking Your Money Out; Twila Slesnick, John C. Suttle
- Money for Life: Turn Your IRA and 401(k) Into a Lifetime Retirement Paycheck; Steve Vernon
- The Truth About Protecting Your IRAs and 401(k)s; Steve Weisman
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