It seems like every few years the government introduces a new retirement plan. Even though it’s getting hard to keep track of all the different types, at a minimum, a savvy investor should have a basic understanding of each option and whom it can benefit most.
The Roth 401k was authorized by the IRS in 2006 and many employers now offer it in conjunction with a 401k plan. Like the name sounds, this type of retirement savings plan combines some of the most desirable aspects of a Roth IRA and a 401k. Although this may sound advantageous, I’ll explain why a Roth 401k doesn’t make sense for most people.
401k and Roth IRA Explained
Most people are familiar with how a 401k works. You contribute pre-tax dollars to your account, which reduces your AGI(Adjusted Gross Income), thus reducing your tax burden. When you take money out in retirement, you pay taxes on the entire amount (contributions + earnings). A 401k basically defers taxes to when you retire and you’re(usually) in a lower tax bracket. On the other hand, with a Roth IRA, you fund your account with post-tax dollars, essentially prepaying your taxes now so that you will be able to take tax free withdrawals on your contributions and earnings in retirement. This option is usually best for people who plan on having a higher income in the future. The Roth IRA has a $5,000 yearly limit while the 401k has a $17,000 yearly limit.
Roth 401k
A Roth 401k is said to combine the best aspects of both plans. You contribute post-tax dollars, as you would to a Roth IRA, but the yearly limit is $17,000 just like a 401k. Your total 401k contributions and Roth 401k contributions cannot be greater than this amount. Similarly to a Roth IRA, the Roth 401k offers the advantage of tax free distribution in retirement but without the income restriction of a Roth IRA.
The problem with the Roth 401k lies in the fact that it is most beneficial to those of us with lower incomes who usually can’t afford to contribute as much post-tax dollars. It allows you to prepay your taxes at a low rate and withdraw later in retirement. However, most people in lower tax brackets may find it challenging to contribute significant post-tax dollars to a Roth IRA and Roth 401k.
A Roth IRA allows for greater flexibility compared to a Roth 401k. You should always contribute to the former before the latter. In fact, Roth IRA contributions can be withdrawn at any time tax free. However, when you take a nonqualified distribution from a Roth 401k, you must report income earnings in proportion to the account’s earnings. Here’s an example:
Roth 401k Balance: $100,000
Contributions: $80,000
Earnings: $20,000
If you take a distribution of $10,000, you will have to pay ordinary income taxes on 20% of that. If this was a Roth IRA, you could take out up to $80,000 tax and penalty free for any reason.
So who does it help?
A Roth 401k can be most beneficial to low-income earners that plan on making more later in life. If you are able to contribute to a Roth 401k in addition to your Roth IRA, you will essentially be prepaying your taxes now to avoid a higher tax rate later in life. PhD and medical students would be the perfect example of someone whom this might benefit.
I recommend a 2:1 contribution ratio of 401k:Roth IRA contributions. For every $2,000 I put into my 401k, I’ll put $1,000 into my Roth IRA(up to the $5,000 limit). It’s too hard to try and predict what tax rates will be like in the future, but if I had to guess, I would say they’re going up!
Do you contribute to a Roth 401k or Roth IRA? Where do you think tax rates are headed?
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The Roth 401k sounds quite complicated. In fact, I have a difficult enough time keeping up with the Roth IRA and the 401k. I think that it’s wise to diversify the assets between the two. There is no telling where tax plans are headed or by what means contributed funds will be confiscated by changes in tax law. For example, it would not surprise me if the 401k plans were nationalized in some manner in order to collect more tax revenue in the near term. Similarly, tax laws could change in order to reduce tax benefits of the Roth IRA. Therefore, I would not give too much thought into the projected tax rates. However, I try to maximize the Roth IRA contributions before contributing more than the 401k matching rate (assuming the company matches and assuming that I have enough funds to do so!)
I agree with you. There is a lot of speculation that the government may try and change some tax laws in the future. And Roth IRA’s may be an easy target when people start pulling out all this money tax free. But IMO, the Roth IRA’s flexibility is what makes it so essential to a diversified retirement portfolio.
An advantage of the Roth401(k), is that you can “raise” the limit on what you can put in your 401(k). Of course, this only works if you max out the contribution.
That’s a good point, but most people who can afford to contribute 17.5k after tax(that’s a lot!) are probably making a lot of money in which case it would make sense for them to contribute to a 401(k) right to get the tax deduction.