Breaking Down the Roth 401(k)
Over the years retirement saving plans have changed. The once common pension plan is now a thing of a past and more of a mythical creature that I hear my parents talking about. Today the 401(k) – 403(b) if you work for a non-profit or public school system – is the mainstream retirement savings plan. Many employers will match a certain percentage of your contributions, helping you save for retirement.
The Roth 401(k) started about 10 years ago but it seems like not a lot of companies are offering this option; for me it became available about two years ago. If you are a young worker or would like to diversify how your money is invested than contributing to a Roth 401(k) may be a great option for you.
Traditional 401(k) vs Roth 401(k)
A 401(k) is an employer-sponsored investment account and the two types of 401(k) are the traditional and the Roth. The traditional 401(k) uses pretax money to fund the account; the Roth 401(k) on the other hand uses after-tax money.
If your paycheck is $5,000, the traditional 401(k) would be taken from the $5,000, lowering the amount you’re taxed at that time. The Roth 401(k) would use money after taxes have been taken out, so you’d be taxed on the total $5,000 then the contribution amount for the 401(k) would be taken out.
The tax on the distributions – the money that is taken out after you retire – is taxed differently as well. When you take money out of a traditional 401(k) the contributions as well as earnings will be subject to taxation. The distributions on a Roth 401(k) are not subject to taxation, since you were taxed on the original contribution you’re not taxed again, also the earnings on the contribution are not taxed.
Don’t Confuse a Roth IRA with a Roth 401(k)
Although both types of Roth accounts may be taxed similarly they are two different types of accounts. Similar to the Roth 401(k) the Roth IRA is taxed prior to making contributions and once you enter retirement there will be no taxes on the withdrawals.
The difference between an IRA and a 401(k) is that a 401(k) is an employer-sponsored retirement plan; whereas an IRA can be opened by anyone under the age of 70.5. An IRA is not connected to your employer. Also, the contribution limits for a 401(k) are much higher than the limits for an IRA.
401(k) Contribution Limits
Contributions are subject to change based on government rules but for 2017 participants can elect to contribute up to $18,000 of their compensation, if you are 50 and older you can contribute an additional catch-up amount of $6,000.
The overall contribution limit which would include your elective contribution plus any employer matching is $54,000; with the $6,000 for catch-up if you are 50 and older still applying.
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Should You be Contributing to the Roth 401(k)?
The decision to contribute to a Roth 401(k) versus a traditional account can be complex and your decision on which one to contribute to will be largely based on your age and what your income is now versus when you retire.
The younger you are and the earlier you are in your career the more advantageous the Roth option becomes as your contributions will continue to compound tax-free. If you’re later in your career you don’t have time on your side to allow the contributions to grow, however if you’re planning on leaving it to heirs who might not withdraw from it for a long time then you might want to think about putting it in the Roth.
Also, your decision to contribute to the Roth should depend on what your current tax bracket is now compared to when you are in retirement. If you think you will be in a higher income bracket at retirement then it might be better to contribute to the Roth now – by contributing now while you’re in a lower tax bracket you’d be taxed less compared to when you retire. If you think you’ll be in a lower tax bracket during retirement it might be better to contribute to the traditional plan and get the tax break on your current income.
Another thing to consider when thinking about contributing to a Roth option is tax diversification as it is difficult to predict what your income level will be in retirement or what changes the government may make with taxes. You can make up for this by putting some money in the Roth option and some in the traditional plan.
If you’re closer to retirement and have only had the option of the traditional 401(k) and recently have been given the option to contribute to the Roth option you might want to look into doing this so that you have some distributions that are not going to be counted as taxable income when you retire.
There is a lot to consider when planning retirement, if you’re just starting out in your career it is important to plan early. If you’re late in your career it is important to make sure you have enough saved before retiring. The Roth 401(k) can be a great option if you are young or in need of tax diversification during retirement. As there is so much to consider and everyone’s individual circumstances are different it is best to speak with a financial adviser about your personal situation and what to do based on your goals.
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