What is a Roth 401(k), how taxes differ from the traditional 401(k), and other considerations for your retirement savings.
There are many retirement savings options for people today. One of the lesser-known options is the Roth 401(k). Since January 1, 2006, U.S. employers have been allowed to amend their 401(k) plan document to elect Roth IRA type tax treatment for a portion or all of their retirement plan contributions.
Let’s cover why a Roth 401(k) may be right for your situation. Special thanks to NerdWallet for some of the details on this article.
What Is A Roth 401(k)?
According to Investopedia…
A Roth 401(k) is an employer-sponsored investment savings account that is funded with after-tax money up to the contribution limit of the plan. This type of investment account is well-suited to people who think they will be in a higher tax bracket in retirement than they are now.
The Roth 401(k) can be a great investment vehicle for the right person. The key is whether you want to pay taxes on your contributions now or on your distributions during retirement. The contribution rules for a Roth 401(k) are exactly the same as for a traditional 401(k). Currently that limit is $18,000/year or $24,000/year for those 50 or older – indexed each year.
Note: that this is the maximum contribution for either or a Traditional and Roth 401k; in other words, you cannot fund $18,000 into a Roth 401k and also $18,000 into a Traditional 401k).
More Money Now Or Later?
Contributions to a Roth 401(k) can hit your budget harder today because of the additional tax withholdings. That’s because after-tax contribution takes a bigger chunk of your current paycheck than a pretax contribution to a traditional 401(k). So it often costs you more to use a Roth 401(k) on the front end.
On the back end, the Roth account can be more valuable in retirement. That’s because when you pull a dollar out of that account, you get to keep that entire dollar. In addition, growth is compounded tax free in a Roth. However, when you pull a dollar out of a traditional 401(k), you only keep the after-tax value of the dollar.
Pros & Cons of the Roth 401(k)
One reason to opt for a Roth 401(k) relates to tax rates before and during retirement. If your tax rate is low now and you expect it to be higher in retirement, you can make contributions with after-tax dollars — which you can do with a Roth 401(k). At that point, you won’t pay taxes at that higher rate when you take qualified distributions in retirement.
Another reason to go with the Roth 401(k) is the potential for tax rate increases. Because government expenses tend to continue to grow, there’s a possibility of future legislative tax increases; current tax rates are low historically-speaking. That would be an incentive to pay taxes now in a Roth account compared to later with a traditional 401(k).
A final reason to go with a Roth 401(k) is you can roll your funds into a Roth IRA which is not subject to Required Minimum Distributions (RMDs). With a traditional 401(k), you are required to take distributions at age 70 ½. Not so with the Roth 401(k) if it’s properly managed.
However, if your tax rate is higher now than you expect it to be in retirement, then a traditional 401(k) may make more sense. You’ll then pay taxes at that expected lower rate when taking distributions in retirement. Many retirees often live frugally, resulting in a lower tax burden so the traditional 401(k) is often the best option.
Roth vs. Traditional 401(k)
Image from NerdWallet
Check With An Experienced Advisor To Discuss Your Options
If you anticipate higher income in your retirement years because of deferred compensation or other income you’re expecting, it might make sense to start contributing to a Roth 401(k). There are several options to consider besides current tax rates, and because future assumptions are unknown, there is not a simple or “right” answer.
To chat with an experienced advisor at Republic Wealth Advisors about whether contributing to a Roth 401(k) may be appropriate for your situation, please reach out today. We’ll be happy to walk you through the pros and cons of different retirement savings options, including the Roth 401(k).
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