WTF (What the Finance) is a Roth 401(k)?
More and more employers are making the Roth option available in their 401(k), 403(b), and 457 plans.
What does this mean?
Well, the default contribution to retirement plans has always been tax-deferred. Meaning, you are legally hiding income for the current year, enjoying paying no taxes on the dividends and capital gains on the account, but pay income taxes on the withdrawals at retirement. Basically, kicking the tax can down the road on retirement investments.
In the mid-90s the Roth IRA was invented to allow contributions to an IRA where you didn’t tax an up-front tax deduction, but growth in the account could be withdrawn tax-free at retirement. Great deal!
In 2006, Roth contributions to 401(k)s became available. This allowed the saver to choose to save tax-deferred, tax-free, or a combination of both. Adoption has been slow, but now about 70% of employers offer the Roth option in their retirement plans.
Why consider using a Roth 401(k)?
First, the pesky income limitations that keep those earning over $133,000/year ($186,000 for couples) from contributing to a Roth IRA are non-existent in a Roth 401(k). Any plan participant can elect the Roth option. Also, while a Roth IRA has a $5,500/year ($6,500 for ages 50+) contribution limit, the Roth 401(k) allows up to $18,500/year ($24,500 for 50+) so you can really build that tax-free retirement asset.
It’s hard to think about giving up your nice top-line income reduction from a tax-deferred 401(k) contribution but consider this: If all of your money is saved tax-deferred, every time you withdraw in retirement a tax bill is triggered. Roth distributions create no tax bill, and when you are retired, you will love having a pool of money that is available tax-free.
And remember, it’s not an all-or-nothing decision. If you are interested in the idea of the Roth 401(k) but worried how losing the deferred benefit will affect your paycheck, start with just a little at a time to Roth. You may decide to increase the percentage going forward.