Bill Roth was a Senator from Delaware. He realized in the late 1990s that savings rates were too low in the U.S. and he endeavored to find a solution. Enter the Roth IRA. Contributions to a Roth IRA won’t reduce your tax bill now because, while pretax salary goes into a Traditional IRA, after-tax money funds the Roth. But withdrawals from Roth IRA’s are tax- and penalty-free as long as you’ve had the account for five years and are at least 59½ when you take the money out. In 2006, a Roth 401(k) was added to this arsenal of retirement choices.
If your employer offers a Roth 401(k) option, here are a few things to know:
- There are no income limits on Roth 401(k) contributions, so these accounts provide a way for high earners to invest a significant amount in a Roth.
- Contribution limits follow the traditional 401(k) limits, so are much higher than the Roth IRA limits. In 2018, you can contribute up to $18,500 to a Roth 401(k), a traditional 401(k) or a combination of the two. Workers 50 or older can contribute up to $24,500 annually.
- As with a Roth IRA, under current tax law when you retire and begin to draw on the Roth 401(k), none of the contributions or gains are taxable.
- You are required by regulation to begin drawing a minimum amount on your traditional IRA or 401(k) at 70½ years old, and those distributions are taxable since they were not taxed when you contributed. You are not required to take a distribution from the Roth at 70½, so you can let it grow throughout your life with no tax consequences for you or your heirs.
- Younger workers stand to gain the most from investing in a Roth 401(k) because they will enjoy many years of tax-free growth. Typically, younger workers are likely to earn less, so they also may not need the pre-tax contributions that come from a traditional 401(k).
- If you expect your tax bracket to decline when you retire, the Roth 401(k) loses some of its appeal, but it still can benefit workers closer to retirement as they still get the tax-free growth for as long as they don’t need to draw on the Roth.
- The benefit of the Roth is less if you expect your tax bracket to drop significantly in retirement, in which case you might come out ahead with a traditional 401(k) plan. You also have less advantage taking the Roth 401(k) option if you are planning to take out distributions from it within the next 7-10 years after you make the contribution (i.e., it has less time to grow tax-free).
- The law now allows employees to convert funds from a traditional 401(k) plan to a Roth 401(k), if your particular plan allows it. Note that you will have to pay taxes in the year you convert, just as you would if you converted a traditional IRA to a Roth. You can’t change your mind and undo a 401(k) conversion to a Roth.
As you can see, there are many potential positives to a Roth 401(k). However, each individual situation is different, so you should seek advice from your accountant and your financial planner before making a move. And thanks again to the late Senator Roth!
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by Ronald Donato, Jr., CFP®, MBA
Director of Financial Services