Everyone has heard of a 401k, traditional IRA, and Roth IRA. These retirement plans have been around for years and are constantly discussed by the mainstream media. A new investment has popped up over the past few years known as the Roth 401k. Roth 401k’s combine the best aspects of a Roth IRA and the best aspects of a traditional 401k; investors get the best of both worlds. Let’s take a look at a few facts about the Roth 401k:
Tax-Free Earnings Growth
A Roth 401k allows earnings to grow tax-free just like a Roth IRA does. Investors sacrifice the tax deduction today for tax-free growth tomorrow. As an example, let’s say you contributed $10,000 to your Roth 401k during the year. In a regular 401k, you would be entitled to a $10,000 tax deduction that same year and would ultimately pay your taxes upon withdrawal of the funds and any appreciation in the account. So let’s assume that same $10,000 grew to $100,000 over a 30-year time frame. In a regular 401k, you would have to pay taxes on the $100,000 withdrawal. But with the Roth 401k, since you payed the taxes upfront, you would not have to pay taxes on the $100,000 withdrawal. Thus, with a Roth 401k, while you will lose out on the the $10,000 deduction this year, you will gain the $100,000 sum tax-free. This treatment is similar to a Roth IRA.
Pro tip: Do you already have a Roth or Traditional 401k set up through your employer? Sign up for a free 401k analysis through Blooom. They will look to make sure you are diversified, that you have the proper asset allocation and that you aren’t paying too much in fees.
The great thing about a Roth 401k is that employers can contribute to your retirement plan just like in a traditional 401k. Roth IRA’s do not allow employee matches. Also, don’t forget that unlike employee contributions in a Roth 401k, employer matches are made with pretax dollars. Thus, the employer’s matching contribution accumulate in a separate account that is taxed as ordinary income upon withdrawal. This is a unique component of the Roth 401k in that it combines the taxation rules of both the Roth IRA and the traditional 401k.
The current Roth 401k contribution limit is $16,500 for adults that are under the age of 50. Adults that are 50 and over can contribute $22,000 due to catch up provisions. This is a big advantage over the much smaller $5,000 to $6,000 contribution limit on the Roth IRA.
No Income Requirement
Do you make too much money to contribute to a Roth IRA? Well, that is not a problem with the Roth 401k. Roth IRA’s have income limitations that prohibit high-income earners from taking advantage of these plans. To qualify for any deduction in a Roth IRA, single filers can only contribute the full amount if their income is less than $105,000 and a partial amount if their income is less than $121,000. Married filers can only contribute the full amount if their income is less than $167,000 and a partial amount if their income is less than $177,000. Roth 401k’s have no income limitations, so even high income individuals can benefit from this plan.
How To Open A Roth 401k
Roth 401k’s are company sponsored plans that have to be offered by your employer. You can suggest that your company adopt this plan if your employer doesn’t currently offer this plan. Many employers are unaware that this type of retirement plan even exists. A Roth 401k is a good retirement vehicle for young employees with a moderate salary. These individuals are already in a lower tax bracket, so they will not benefit as much from the tax deduction today. Their salaries will likely increase dramatically over the next 20 to 30 years thus placing them in a higher tax bracket. They can forego the higher taxes upon withdrawals during their peak earning years and avoid losing out on any appreciation in their Roth 401k.
Does you company offer a Roth 401k? Does it sound like something that you would be interested in?
(Photo credit: Digital Sextant)