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Is a Roth 401(k) right for you?

Is a Roth 401(k) right for you?

June 28, 2018

In the Revenue Act of 1978, the 401(k) retirement savings plan was born. This law gave employees the choice to receive a portion of their earnings as deferred compensation held in a special account. The employees did not pay tax on that money in the year it was earned. They would pay income tax in the year it was spent.

Then the Economic Growth and Tax Relief Reconciliation Act of 2001 included a provision to be effective in 2006 that would create a Roth 401(k) account. In the 12 years since, company sponsored retirement plans have had the option to include a Roth options for workers. According to a study by Transamerica, 52 percent of plan sponsors offer a Roth 401(k).
It’s likely you have the choice to save into a Roth 401(k) at work. Check with your human resources office to see if it’s an option. If it’s not, ask them to consider adding it to the plan. It typically isn’t expensive for the company to include a Roth 401(k).
What is the Roth 401(k)?

  • It’s a type of retirement savings account inside the 401(k).
  • Money in the Roth 401(k) grows tax deferred and is not taxed when distributed.
  • You do not get a tax deduction for the savings. You pay tax as a normal part of payroll deduction.
  • As of 2018, you can save as much as $18,500 of your earnings. If you are better than 50 years old, you can save an additional $6,000 each year for a total of $24,500 each year.
  • You can take distributions from the account after leaving the company and after age 59 ½ without penalty.
  • Employer matching contributions will be made into a traditional 401(k) account. You will not pay taxes on the deposits when made. You will pay taxes on distributions as ordinary income when you spend the matching money.

Why use a Roth 401(k)?
My retired clients love their Roth accounts. They can spend money without paying taxes. They hate taking money from their IRAs because every distribution gets taxed. For example, if they want to spend $10,00, they need to take out $14,286 from the IRA to allow for $4,286 in taxes.
Roth IRA accounts are limited to contributions of $5,500 each year and $6,500 if you are over 50. So, using the Roth 401(k) gives you a substantially larger Roth bucket each year.
You may pay higher taxes in retirement than you do now. The 2018 tax bill reduced individual tax rates, but only through 2025. Then the rates revert to the prior, higher levels. Nobody knows what will happen in eight years, but the baseline will be higher taxes.
Difference between a Roth IRA and a traditional IRA
Here’s an example of the difference between a Roth and a traditional IRA with a $20,000 initial contribution.
Roth IRA:

  • You make a $20,000 Roth contribution now and pay $4,800 in income tax on that money.
  • Your family makes $200,000 in 2018 and pays about 24 percent income tax.
  • The money grows for 20 years and is worth $50,000.
  • You spend it all and pay no tax.
  • You invested $24,800 between the savings and the income tax to get $50,000 to spend. That’s a net of $25,200 after-tax benefit.

Traditional IRA:

  • You make $20,000 Traditional IRA contribution now and receive a reduction in income that saves you $4,800 in income tax this year.
  • The money grows for 20 years and is worth $50,000.
  • You spend it all and pay tax based on the rates from 2017.
  • Your total income in 2038 is $200,000 including this distribution.
  • The tax rate is 28 percent.
  • You pay $14,000 in tax on the $50,000 distribution, leaving you with $36,000
  • You saved $20,000 and cut your 2018 taxes by $4,800 for a net investment of $15,200.
  • So, you invested $15,200 to spend $36,00. That’s a net after-tax benefit of $20,800.

Your after-tax benefit was $4,400 more with a Roth IRA. And in case you care, you paid $9,200 more in income taxes with the traditional IRA.
But of course, this example may not have much to do with your situation. Everything in financial planning is relative to your personal goals and priorities.
So, if you really want to know if a Roth 401(k) is a great idea for you, I suggest you take some time to reflect on your goals, how things are going and how to be sure about how things are going.
A great place to start is to meet with a CERTIFIED FINANCIAL PLANNER™ professional who is an advocate for the client– a fiduciary advisor – and who only works for the client – a fee-only advisor – to discuss and talk about your financial plan.
A CFP® professional can help you create a comprehensive financial plan that is driven by your goals and priorities and addresses all aspects of your financial life. With a big-picture approach, you will get a meaningful understanding of your goal progress. And, you will get a personalized action plan for how to move forward.
Yes, I am a CFP® professional. I’m always a fiduciary and I only work on a fee basis. And, yes, I’m still taking on a few great families to be part of my financial planning practice.
If this article has you thinking about your own circumstances, contact my office at I am always happy to meet with people who are working on their retirement plans. Dunncreek Advisors does not provide legal or tax advice, nor is this article intended to do so.