What is a Roth 401k Plan?
The classic 401k is largely the same from employer to employer, although there are some subtle differences. But the Roth option is a game-changer, and an increasing number of employees who have the choice are taking it.
According to the Aon Hewitt report, 2014 Universe Benchmarks: Measuring Employee Savings and Investing Behavior in Defined Contribution Plans, more employees are choosing the Roth 401k option every year. In 2011, about 8 percent of workers contributed to a Roth account. But in 2014, that number had grown to 11 percent.
What makes a Roth option different from a traditional employer-sponsored 401k? It’s primarily about when and how much you want to pay Uncle Sam. When you pay him can make a tremendous difference in how much. Here’s what you need to know.
A 401k Plan Primer
Before you can decide which plan is right for your retirement savings, you need a good foundation in the 401k concept. The classic 401k and the Roth 401k option are the same in many ways.
Generally, a 401k or 401(K) is an employer-sponsored retirement savings vehicle that allows you to contribute a portion of your paycheck before taxes. The name is derived from the IRS code that deals with these plans, which emerged in the 1980s an alternative or supplement to traditional pensions.
In many cases, employers match the employee contributions, but to varying degrees, which is one reason why they’re so attractive. Another reason is because pre-tax contributing gives you more available cash to invest.
The Wall Street Journal explains that most plans spread employee contributions among mutual funds, stocks, bonds and money market investments. Each plan has an administrator, and employees can take distributions in retirement.
Withdrawals can also be made before retirement, but usually at a huge penalty. And depending on whether or not the employer contributions are fully vested right away, you might not be able to tap into that part of your investment early. Most employer contributions become fully vested gradually over time. But after a certain length of employment, they might vest immediately.
So, What is a Roth 401k Plan? What Makes a Roth 401k Different?
There are several variables within 401k plans. However, the most significant difference between a classic 401k and a Roth option is WHEN you pay your taxes.
- With a classic plan, all of your contributions are made before your income has been taxed. It’s sheltered in the account until you retire, and then you pay taxes on only the portion that you withdraw.
- So, what is a Roth 401k plan? A Roth plan is taxed on the front end. You pay taxes when you invest the money. But once it’s time to take distributions, you won’t have to pay Uncle Sam because you’ve already done that. So, if you get great investment returns on your money, those returns are tax free.
Why would you choose to pay on the front end? There are numerous benefits. For example, once you retire, you might be in a higher tax bracket from the one that you’re in now. Paying income tax on your current earnings now instead of waiting until later gives you some control over how much you’ll pay.
A Roth option is also something to consider if you plan to leave the plan to your spouse or heirs, says Ashlea Ebeling for Forbes. The plan could be stretched out and grown tax-free.
For younger workers, Roth is often a good choice. You’ll have “decades of tax-free earning potential,” says Ebeling. According to Fidelity Investments, the same $5,000 contributed by Hypothetical Elaine to a Roth plan would yield significantly more in 30 years than the same amount contributed by Hypothetical Tom to a traditional 401k.
Fidelity says, “With tax rates and investment returns being equal, Tom’s initial contribution will have grown to $27,404, after paying taxes at the time of withdrawal, while Elaine will have $38,061. Choosing the Roth 401(k) gave Elaine $10,657 more than Tom.” The example assumes a 30-year investment, 7 percent compounded annually, and a tax rate of 28 percent on the front end for Roth and on the back end for a traditional 401k.
Pay it now or pay it later, eventually your savings will be taxed.
Roth Sounds Great but It’s Not Perfect
The Roth 401k can be superior to a traditional 401k. However, you will want evaluate the downsides.
There is a case against investing in a Roth 401k. For some, paying taxes on the investment in retirement won’t be a special hardship. In fact, it could be a good plan. For example, if you retire in a state where you’ll owe a gentler income tax debt, you could come out ahead with a classic 401k instead of paying the higher rate now on the front end.
According to senior partner at Hanson McClain Advisors, Scott Hanson, for CNBC, people who live and work where there’s a high state income tax rate for top earners, such as CA, and then move away in retirement might be better off with a traditional plan.
“If you plan on leaving California for Texas or Nevada upon retirement, as thousands of Californians do, your federal tax rate would have to be at least 13 percent higher just for a Roth conversion to break even.”
What is a Roth 401k Conversion?
If your employer allows it, you might want to consider the pros and cons or converting your traditional 401k into a Roth 401k. With a conversion, you simply shift the tax status of your savings.
When you convert, you transfer your 401k savings into a Roth 401k. At this time, you pay income tax on the amount you are moving into the Roth 401k account.
Converting a traditional 401k to a Roth plan could also leave you with a big tax debt. You could contribute to both a traditional and a Roth plan at the same time. But shifting your money out of a tax-deferred plan and into a Roth means you’ll have to pay up.
Fidelity Investments recommends avoiding the shift if you’ll have to use part of your investment to pay the taxes due. For people under the age of 59 1/2, that could mean that you’d not only lose that part of your investment but also face the 10 percent early withdrawal penalty for the portion that you take out. That said, a shift might work out fine if some of the cash in your traditional 401k is after-tax money.
A Roth 401k plan is one of the newer investment vehicles that employees have at their disposal. And a lot of workers are embracing it.
Still, some feel that the traditional plan is best. The outspoken and irreverent financial blogger, Sam Dogen of Financial Samurai, says paying taxes up front is a bad idea because, among other reasons, a) the government wastes your tax dollars so you’re better off keeping them in your possession for as long as possible, and b) the government could get more of your money if you pay your taxes up front.
Are You Saving Enough for Retirement?
How ever you choose to go about retirement investing, most experts agree that saving money somehow somewhere is what is really important.
Whether it’s a classic 401k, Roth 401k, IRA or any other savings plan, just save.
If you need motivation to save, you might try out a retirement calculator. These tools can help you imagine your future and tell you exactly how much money you need to have saved for a secure and happy retirement. The NewRetirment calculator was recently named a best retirement calculator by the American Association of Individual Investors (AAII).