Roth 401(k) – An Option to Consider
The Roth 401(k) is becoming an increasingly common option in workplace retirement plans. There are a few very distinct differences between the Traditional (pre-tax) 401(k) and the Roth 401(k) options that can provide great benefits when reaching retirement. Most, but not all, employees would benefit from taking advantage of the Roth option. It is important to understand the rules and functions of the Roth 401(k) before deciding to contribute.
In 2006, the Roth option in 401(k) plans was first made available. When contributing to a Roth 401(k), the employee is making contributions with after-tax money. At retirement those contributions, along with all of the account growth, can be distributed completely tax free. This means that money contributed to a Roth 401(k) today could potentially grow for 10, 20, or 30+ years and with all earnings being tax free. This differs from the Traditional 401(k) where contributions are made with before-tax dollars and then, at retirement, distributions are fully taxable. The biggest benefit of the traditional 401(k) option is the upfront tax savings, especially for high income earners.
There are some situations where utilizing the Roth 401(k) makes a lot of sense. For younger employees with many years until their retirement, the compounded growth with no taxes due at distribution is very appealing. There is also no income limitation on who can contribute to a Roth 401(k). For those high income earners who may not qualify for a personal Roth IRA, the Roth 401(k) provides the same benefits without the income restrictions. Also, those who feel they will be paying a higher tax rate in their retirement years would save by paying the taxes up front when utilizing the Roth 401(k). It can also provide a sense of certainty for those worried about future tax increases.
For high income earners, the loss of the upfront tax savings that comes from contributing to a Traditional 401(k) can make the Roth 401(k) less appealing. Those paying significantly higher tax rates than they expect to pay in retirement generally favor the upfront tax benefits gained by contributing to a Traditional 401(k). That said, most people still benefit from diversifying assets across varying account types. Building funds in a combination of pre-tax accounts (Traditional 401(k) or IRA), Roth, and after-tax accounts grants a very desirable amount of flexibility when reaching retirement – enabling retirees to minimize their tax burden throughout their retirement years.
Though relatively new, the Roth 401(k) option is now available in about 50% of 401(k) plans and continues to grow in popularity. Many employees would benefit by dedicating at least part of their 401(k) contributions to the Roth option (though high income earners and those nearing retirement should analyze further.) Recently advanced planning options like in-plan Roth 401(k) conversions have become available, further expanding the flexibility of plan participants. We receive many questions on the Roth 401(k) option and can help to determine if it makes sense in your personal situation. If you are curious or have any questions, please contact one of our advisers.