Roth 401k Option? Your Employer Likes You!

A Roth 401(k) invested wisely will blossom into a large nest egg with the help of tax free earnings.

If your employer hasn’t added a Roth 401k option to your retirement plan, tell them to get with the program! Maybe a nice note dropped off at HR might help?

Roth or post-tax contributions aren’t for everyone, but it’s nice to have the option. Earnings on these types of contributions accrue tax free. If you expect a lot of earnings, these post tax contributions can be a huge boon to your after tax rate of return.

Plus, it helps to diversify how you're saving for retirement. Most folks welcome being able to make both taxable and non-taxable withdrawals from their 401k type plan when they retire.

 Roth 401k vs Roth IRA

When it comes to Roth 401k vs Roth IRA, there are at least 4 good reasons to have both, even if you’re making all Roth contributions at work.

If you’re a good saver, a Roth IRA gives you one more reason to have both a 401k and Roth IRA: You’ll be able invest more tax advantaged dollars. In 2017, a Roth IRA gives you an extra $5,500 you can invest ($6,500 if you’re 50 or older).

If you are a lower wage earner, or your income is down because of a layoff, illness, or cutback, don’t forget the very valuable savers tax credit. If you qualify, you'll get tax free earnings and a tax credit, all in the same tax year!

Let’s review the two types of 401k contributions:

Roth (post-tax) contributions

Roth 401(k) payroll contributions are made post-tax, meaning they’re included in your gross income in the year of the contribution and taxed at ordinary income tax rates. Earnings accrue tax free, not tax deferred like with pre-tax contributions.

It’s a pay me now or pay me later scenario. By paying your tax now rather than later, you’ll enjoy tax free withdrawals on both your contributions and associated earnings if qualified.

Qualified simply means you’ve reached age 59 ½ and five years have eclipsed since your first Roth 401k contribution. Some employers also require you to be separated from service from them before you’re able to make qualified withdrawals, while other employers allow tax free in-service withdrawals.

If your employer offers a match and/or a non-elective contribution, it’s always made pre-tax, so your 401k will have a pre-tax element even if you make all Roth contributions.

As you get older and closer to retirement, it pays to know the Roth 401k rules so you can avoid Required Minimum Distributions when you reach age 70 ½. A simple Roth 401k rollover is all that’s needed to avoid those nasty RMDs.

Traditional (pre-tax) contributions

All employers who offer a 401(k) offer a pre-tax or traditional option, or it’s their only option. Some employers have added a Roth option since it was first allowed in 2006, but many have not.

Pre-tax contributions are not added to your gross income for the year. If you’re subject to the higher tax brackets, that means less money is taxed at 33%, 35%, or 39.6%, making the tax deduction especially valuable for higher wage earners.

In addition, many tax deductions and credits are based on your adjusted gross income (agi). If your agi is too high, you can’t take the deduction/credit. Pre-tax contributions reduce your agi, so you could save even more on taxes.

Because tax is deferred on both contributions and earnings, there is no year to year tax liability on capital gains and dividends like you’d have in a regular taxable account.

That’s the good news. The bad news is the entire amountboth contributions and associated earningswill be taxed at ordinary income tax rates when you take it out.

If you’re in a lower tax bracket than when you made your contribution at the time of withdrawal, the utility of your pre-tax contributions increases even more; however, what income tax rates will be in the future is anybody’s guess.

Do you think tax rates will be higher or lower in the future? If you guessed higher, then you know this pre-tax money is like a ticking time bomb. If Congress authorizes higher taxes (like they did a few years ago), that could mean less money for retirement.

What type of contribution should I be making?

Which type of contribution you should make depends on many factors including tax bracket, current income needs, age, and your projected future tax bracket:

The younger you are and the less money you make, the more you should favor Roth contributions. The thinking here is if you’re just starting out, you’ll probably never be in as low a tax bracket as you are then, so it makes sense to get the tax liability over with. Plus, because you’re young and that money is going to compound until you’re at least age 59 ½, you can expect more earnings (which are tax free) than someone who is older.

Contrarily...

The older you are and the more money you make, the more you should favor pre-tax or traditional contributions. The thinking here is if you’re making the big bucks, that extra tax savings means a lot more because of your higher marginal tax bracket. Plus, tax free earning won’t be as great as when you were younger because your time horizon for investment isn’t as long as it used to be.

More than likely you’re somewhere in-between these two descriptions, which probably means you should be making both types of contributions. You can do that, you know. As long as you don’t exceed the Roth 401k contribution limits, you can split your payroll contribution and invest both ways in any ratio you want.

When cash flow is tight, realize all pre-tax contributions over Roth contributions will increase the size of your paycheck (you’ll owe less tax). Conversely, an increase in Roth contributions over pre-tax contributions will shrink your paycheck.

Roth 401k contributions let you choose how to save

Lucky for you your employer likes you and offers a Roth 401k investment option in your 401(k) plan. Who knows, this could be the start of a new era. How about Fridays off, or maybe an on-call masseuse?