Roth 401(k): Why You Should Put Money Here
If your 401k plan allows Roth deferrals and you don’t already use it, now is a great time to reconsider the Roth 401(k). Generally, participants that expect lower tax rates in retirement are probably better off making traditional (tax-deferred) deferrals. However, Congress is considering lower taxes for individuals and corporations. If that happens, Roth deferrals will be more affordable than ever.
Tax Free - Why should 401k participants consider Roth deferrals? They offer a tax-free nest egg in retirement. To earn this benefit, participants pay taxes on their Roth deferrals in the year they are made — at personal income tax rates. This differs from traditional 401(k) deferrals, which are tax-deductible in the year they are made - and then taxed when withdrawn.
While, the ideal candidate is a young worker that expects their income to climb throughout their career high earners with taxable investments can also benefit from Roth deferrals. Unlike Roth IRA contributions, there are no income restrictions for making Roth deferrals. That means high earners can build a large tax-free account over time to hedge against their taxable investments.
The contribution limits are the same for conventional 401(k)s: $18,500 annually if under 50 (higher limits starting in 2018). Add another $6,000 a year if over 50.
Certainty - With tax "reform" up in the air in Washington D.C., we don't know if you'll pay lower or higher tax rates in retirement. Future tax rate uncertainty gives an advantage to the Roth as it provides diversification and certainty in the tax treatment of an individual’s retirement savings. With other types of retirement accounts most – if not all – of an individual’s retirement savings will be subject to taxation when withdrawn.
Flexibility - If you have money in a conventional IRA, you have to take minimum withdrawals at age 70 1/2. With a Roth, you have the choice of leaving your money in the account as long as you like, so it has the added benefit of being used early or later in retirement without affecting your taxes. A Roth 401(k) is a little different in that you are required to take an annual RMD on April 1 of the year following (whichever occurs last):
- Participant turns 70 ½ or
- Year participant retires
5% owners of the 401k plan sponsor must start RMDs by April 1 of the year following when they turn 70½.
However, and this is important, Roth 401k RMDs can be avoided by rolling their amount to a Roth IRA prior to the RMD deadline.
Lower Withdrawals - Once you hit 59 1/2 -- and have your funds in a Roth for at least 5 years -- you don't have to worry about a mammoth tax bill from a 401(k) withdrawal. Say you make a withdrawal from a traditional 401(k) to fund a trip. Taxes will have to be added to the amount you need to cover the taxes and thereby lowering your total account value. With a Roth, if you need $5,000 you only have to take $5,000 out.
When Roth 401k funds are withdrawn as part of a non-qualified distribution, their earnings are taxable at personal income tax rates and may be subject to an additional 10% early withdrawal penalty.
In-Plan Rollover - An in-plan Roth rollover, also called an in-plan Roth conversion, is a reclassification of non-Roth 401k funds to Roth funds. Any 401k plan that includes a Roth feature can permit in-plan Roth rollovers. 401k participants can convert any vested balance, including earnings, to Roth funds.
When a 401k participant makes an in-plan Roth rollover, they must report the rollover amount as taxable income for the year of the conversion and pay the tax due. However, these rollovers are not subject to the 10% early withdrawal penalty or mandatory income tax withholding.
Participants are most likely to make in-plan Roth rollovers in tax years where their income is low or their non-Roth account balance has dropped in value.
Unfortunately, it can be tough for 401k participants to decide whether Roth deferrals are the right choice for them. The two key deciding factors – future income and tax rates – just aren’t predictable.
However, if your 401k plan allows Roth deferrals, you owe it to your future self to consider these contributions — especially if these contributions are made even more affordable by lower personal income tax rates.
Need help with setting up a Roth? Contact your employer's HR department or give us a call for expert, unbiased advice.