Building a Tax-Free Future: 5 Major Benefits of the Roth 401(k)

Most people are familiar with the traditional 401(k) retirement account.  It has become the de facto retirement-saving vehicle for millions of Americans.  At Hosler Wealth Management, we’re big fans of the traditional 401(k)’s tax-free cousin, the Roth 401(k).

Like the better-known Roth IRA, the Roth 401(k) is a powerful tool that can help you create tax-free income in retirement.

What is a Roth 401(k)?

A Roth 401(k) is an employer-sponsored retirement savings account funded by after-tax money. Withdrawals in retirement are tax-free.  This is different from a traditional 401(k), which is funded with pre-tax dollars and defers tax payments to withdrawals in retirement.

In other words, with a traditional 401(k), you get a tax break at the beginning, but must pay taxes when you withdraw funds in retirement.

The Roth 401(k), on the other hand, provides no initial tax break, but allows you to grow your account and withdraw your earnings in retirement tax-free.

Offering an avenue for building tax-free retirement income is a pretty big benefit of the Roth 401(k). But let’s take a look at a few more significant benefits.

No Required Minimum Distributions

Because Uncle Sam wants to get his cut after offering you a tax break while saving for retirement, owners of traditional 401(k) accounts must take a required minimum distribution (RMD) every year after they turn 73 (or 75 if born in or after 1960).

That’s not the case with a Roth 401(k). Because you pay taxes on your money before contributing to a Roth account, there’s never an obligation for you to withdraw a minimum amount.

Depending on your needs, you can leave your Roth 401(k) alone and let it keep growing until you need it.

Higher Contribution Limits

Unlike a Roth IRA, with annual contribution limits of $7,000 for those under 50 and $8,000 for those 50 and over, a Roth 401(k) allows for significantly higher contributions — up to $30,500 per person over 50.

This is another huge benefit that allows you to save and grow exponentially more tax-free income for retirement.

Failing to Plan for Estate Taxes

Many people may not think they’ll owe estate taxes because of today’s exemption amount of roughly $12.9 million per person.

But given that Estate Tax exemption amounts are set to expire in 2025, the current limits are scheduled to sunset, lowering the lifetime exemption amount down to around an inflation-adjusted amount of $6 to $7 million per person.

If your estate is valued at $3 to $4 million today, in a decade, that could easily double, meaning you’d likely have a taxable estate. With current estate tax rates set at 40% for most taxable estates, there can be a lot of tax dollars on the line.

There are tools and strategies you need to explore to protect your family against paying unnecessary estate taxes. Everyone’s situation is unique, and it’s important to consult with a team of estate planning professionals (Financial Planners, Tax professionals, and Estate Planning Attorneys) to explore which solutions will work best for you.

Protection from Higher Tax Rates

We can’t accurately predict the future, but it remains very likely with the state of our national debt that income tax rates will be higher tomorrow than they are today.

That means tax-free accounts like the Roth 401(k) will become bastions of safety for retirees, protecting their hard-earned money against dramatically higher future tax rates.

Failing to Properly Title Assets

This one applies in the nine community property states, including Arizona. You want to appropriately title your assets to ensure the surviving spouse or heir receives a full step-up in basis. This can help avoid capital gains taxes for the surviving spouse.

For example, let’s say a couple buys a rental home for $500,000. It appreciates to a value of $1 million when one of the spouses dies. So long as the property was held in their Trust and held as community property, the surviving spouse will receive a full step-up in basis not only on his or her half of the property (from that initial $250,000 to $500,000) but on
the deceased spouse’s share of the property as well.

That means the surviving spouse could turn around and sell the $1 million rental home and pocket the total sales amount without paying any capital gains tax.

If the home were improperly titled, the surviving spouse couldn’t take advantage of their deceased partner’s step up in basis, resulting in a capital gains tax bill on 50% of the sales price when they sold the property.

Limits Social Security Taxes

Another big benefit of a Roth 401(k) is its ability to limit retirees’ taxes on their Social Security benefits.

For example, if a married couple has taxable income of more than $32,000 in retirement, up to 50% of their Social Security benefits are taxed. That goes up to 85% of Social Security being taxable if the couple’s income exceeds $44,000.

The key phrase here is taxable income. To limit the amount of taxes on your Social Security benefits, you want to maximize the amount of non-taxable, or tax-free, income.  That’s where the benefits of a Roth 401(k) really shine.

Because withdrawals from a Roth 401(k) are tax-free, those distributions don’t count toward a retiree’s taxable income and can protect Social Security benefits from being taxed.

Provides Extra Retirement Flexibility

At this point, many people are likely to already have a good amount of money saved in traditional 401(k)s and traditional IRAs.

If you start saving as much as you can in a Roth 401(k) now, it’s going to provide an additional bucket of flexible tax-free money to pull from in retirement.

Having access to an extra bucket of tax-free income in retirement can be a powerful benefit and offer greater flexibility in terms of planning a higher quality retirement.

Have Questions About Roth 401(k)s?

If you’re looking for additional solutions to create tax-free income in retirement, a Roth 401(k) may be right for you.

The highly experienced team at Hosler Wealth Management can work with you to explore your Roth 401(k) options.

Request a call or send us a message to see how our financial professionals in Scottsdale and Prescott can help you develop a plan of action to create a tax-free retirement.

This material is intended for informational/educational purposes only and should not be construed as specific tax, legal or investment advice. Individual circumstances may vary.

Disclosure: Securities and advisory services offered through Commonwealth Financial Network®, Member www.FINRA.org/www.SIPC.org, a Registered Investment Adviser.  700 S. Montezuma Street, Prescott, AZ 86303. Phone: 928.778.7666.  The Financial Advisors associated with this website may discuss and/or transact business only with residents in states in which they are properly registered or licensed. No offers may be made or accepted from any resident of any other state. Please check Broker Check for a list of current registrations. Information presented on this site is for informational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any product or security.  Fixed insurance products and services are separate from and not offered through Commonwealth. Tax preparation and accounting services offered by Hosler Wealth Management, LLC are separate and unrelated to Commonwealth.  Commonwealth Financial Network® does not provide legal or tax advice. You should consult a legal or tax professional regarding your individual situation.

© 2023 Hosler Wealth Management LLC