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Oct 9, 2018

Overview of Roth 401k. It Helps or it Doesn't?


By Justin Pritchard


Roth 401k allows you to contribute after-tax money to a 401k plan. The idea—if all goes well and you follow all IRS rules—is that you can prepay income taxes today instead of paying those taxes when you withdraw funds in retirement.
If you’re familiar with traditional 401k contributions, it might help to compare and contrast. For decades, 401k plans allowed pre-tax (or traditional) contributions to the plan. Those contributions reduced your taxable income, which may make it easier to contribute (and might even help you pay taxes at a lower rate if you end up in a lower bracket at retirement). However, because that traditional money has never been taxed, the IRS requires you to pay tax on all of the money you withdraw from traditional accounts funded with pre-tax contributions (contributions, and any earnings).
Presumably, you’ll do that in retirement, although you might withdraw early—which could result in additional taxes and penalties, depending on your age.
Current-year tax impact: Like traditional contributions, Roth contributions come out of your salary. But Roth doesn’t reduce your taxable income when you contribute. You’ll pay roughly the same income tax whether you put the money in Roth 401k or you deposit the funds to your bank account.
Tax-deferral: As with most retirement accounts, you don’t have to pay taxes on earnings inside of the account every year.
Roth 401k contributions have been allowed since 2006. But it’s an optional feature, and some employers have chosen not to offer Roth.

Roth 401k Limits

The limits for Roth 401k contributions are the same as for traditional 401k contributions. In 2018, the maximum you can contribute to a 401k (as salary deferral) is $18,500. You can do all of that as Roth, all of it as traditional, or you can direct a portion of your salary to each option. If you’re over the age of 50, you can contribute an additional $6,000 per year.

Employee vs. Employer Dollars

Employee: When you direct part of your salary to a 401k, you’re making “salary deferral” contributions (also known as “employee” contributions). For those contributions, you can choose whether you want to make traditional, Roth, or both types of contributions—up to the total annual limit.
Employer: Your employer might also contribute to the plan and help you build up your retirement savings. Those contributions, known as employer contributions, might be matching contributions, profit-sharing, or other types of contributions. Employer contributions are generally “pre-tax” contributions, and you typically need to pay tax on withdrawals from those accounts.

Does it Make Sense to use Roth?

Roth 401k is simply an option, and it might or might not make sense for you. Speak with your tax preparer or a qualified tax advisor before making your decision.
If you believe that income tax rates will rise in the future, Roth might be a good idea. That could happen in at least two ways, although anything is possible:
  1. Across-the-board tax rate increases: If legislation results in higher rates, it’s possible that you’d pay taxes at a higher rate, even if your income remains the same.
  2. Moving up in the tax brackets: If your income increases and current laws are unchanged, some portion of your earnings might be taxed at higher rates.
Traditionally, the assumption was that you’d be in a lower tax bracket in retirement: You stop earning income from your job, and you have a relatively small income from Social Security (and maybe a pension). If that holds true, Roth could end up being the wrong move. But even then, it’s not so simple—the world is a complicated place. The type of account you use could affect how much income you show on tax returns, which could impact other areas of your finances.
We can never know what will happen, so you need to make some assumptions and educated guesses. If you’re not confident one way or the other, you can always spread the money around by making both traditional contributions and Roth contributions. That way, you’ll have the option to pull from whichever account works best for you when you need funds.

If You Change Jobs

Your 401k provider keeps track of how much you have in Roth accounts, and how much is in traditional accounts. If you change jobs and decide to take funds out of your 401k, you may need two accounts to put the money in. Most 401k vendors send your savings in two (or more) separate payments.
Any traditional pre-tax funds generally go to pre-tax retirement accounts, and Roth funds go into a Roth IRA or Roth 401k. Additional “money types” may exist in your plan, so verify what you have and ask your tax advisor how to proceed before you take a distribution.

Roth 401k vs. Roth IRA

Both Roth 401k plans and Roth IRAs allow for after-tax savings. While the similarities and differences are complicated, several highlights include:
Maximums: Roth 401k has higher annual savings limits, allowing you to maximize your after-tax savings.
Income limits: To be eligible for Roth IRA contributions, your income must be below IRS limits. But those income levels do not disqualify you from making Roth 401k contributions.
Easy access: You can generally pull your contributions back out of a Roth IRA at any time without taxes and penalties (but check with your CPA before doing so to verify if that applies in your situation). However, Roth 401k distributions might require you to take some of the earnings, resulting in potential income taxes and penalties if you withdraw funds early.
Important: The information on this site is provided for discussion purposes only. It should not be used to make important financial decisions that could have expensive consequences. Consult with a qualified professional who has a detailed knowledge of your situation before making any decisions