Roth 401k – What is Roth 401k?

More and more plans are offering Roth 401k. Is Roth 401k right for you?

How Roth 401k Works

Roth 401k is similar to a traditional 401k plan. However, your contributions go in after-tax. Therefore you don’t get a deduction (or reduce your taxable income) when you make contributions to a Roth 401k plan.

Why Use Roth 401k?

The main reason to use Roth 401k (or a Roth IRA) is to try and pay taxes and lower bracket. If you believe that tax rates today are lower than they will be when you take funds out in retirement, then Roth 401k is a good idea.

Another reason to use Roth 401k is to have more predictability when you take money out of your retirement account. Assume you have $100,000 in a traditional 401k. You will not deal to spend all $100,000 because it’s all pretax money. You have to pay income taxes on your distributions, so you might expect to only have $70,000 or so to spend. With Roth 401k, you’ll be a little spend all $100,000 if you can take the money out tax free.

Why Avoid Roth 401k?

It could be that Roth 401k is not a good fit for you. A few reasons include:

  • You need to reduce taxable income
  • It is difficult for you to make sufficient contributions to get the maximum company match
  • You’re in a relatively high tax bracket because you have a high income

What Would Make Tax Rates Change?

Tax rates might go up and down for several reasons. You should evaluate these possibilities when deciding whether or not Roth 401k is right for you.

The obvious reason for a change in tax rates is a change in your income. If you are relatively highly paid, you’re presumably in a higher income tax bracket today. In retirement, you may take less income than you earn today, putting you in a lower tax bracket. In that case, Roth 401k would be a bad idea.

On the other hand, You might have a very low income today. Perhaps you’re just starting out and you’re very young. If you save aggressively, chances are that you’ll have substantial retirement savings by the time you get older. You can pay the income taxes today at a fairly low rate, and take your money out tax free in retirement.

Finally, tax laws will change along with politicians. Remember that you will be saving for retirement for many years. With any luck, your retirement will last many years as well. If you retire at age 65, it’s very possible that you’ll take distributions for 30 years. During that time, tax rates will rise and fall as the political pendulum swings back and forth. You should consider this as you decide how much (if any) to contribute to your Roth 401k.

Roth 401k Contributions

How do you contribute to Roth 401k? if your plan offers a lot of 401k feature, you can decide how much if any to contribute. In 2009, the maximum 401k contribution is $16,500. You can put all $16,500 into Roth 401k, or you can mix and match by putting a portion of the $16,500 into a traditional 401k. Maybe you split it 50/50 – who knows?

Does Roth 401k Have Income Limits?

In the past, you may have been prevented from making Roth IRA contributions because you make too much money. This problem is eliminated with Roth 401k. As long as you are eligible to contribute to the plan, you can make Roth 401k contributions regardless of your income. Of course, if you are a Highly Compensated Employee there may be limitations on how much you can contribute if your company fails discrimination tests.

A Roth Curveball

Keep in mind that we don’t know what the future brings. Some people prefer a bird in the hand versus two in the bush. In this case, some might prefer a guaranteed deduction today versus the promise (which could be broken) of tax-free distributions at retirement. As we said before, lawmakers may change tax laws and make Roth 401k contributions a mistake.

For example, the nation could move towards some sort of consumption tax such as the Fair Tax. In that case, distributions from traditional retirement accounts would not be taxable – and people who made those contributions would have enjoyed reduce taxation when making contributions.

As you evaluate Roth 401k, as with most other personal financial decisions, you need to remember that we have no idea what the future brings. The best we can do is make some assumptions and reevaluate over time.