For many years the only way to save for retirement within a 401(k) plan was by contributing pre-tax dollars. Depending on your contribution rate, every pay period your employer deducts a predetermined amount from your paycheck and transfers it directly to your 401(k) account. Since all contributions are made with before-tax dollars, you don’t have to pay any taxes on the contributions and basically, minimize your taxable income.
Starting January 1st, 2006, the Pension Protection Act allowed employers across the country to amend 401(k) plans and offer a Roth contribution program. A new Designated Roth Account, better known as a Roth 401(k), permitted plan participants to make contributions with after-tax dollars. Besides that, all other rules for the Roth 401(k) account are basically the same as for the Traditional 401(k), including the employer’s contributions being made of before-tax dollars.
Since its inception, over 60% of all plans offer Roth options to their participants. As the name implies, a Roth 401(k) has many similarities with a Roth IRA. However, a few key differences make them very different at the same time. Before you decide which one to choose it’s best know them.
Why Consider Roth?
As I already mentioned, unlike a Traditional 401(k) where you make before-tax contributions and reduce your taxable income for the amount contributed, both a Roth 401(k) and a Roth IRA are made with after-tax dollars. That means that contributions to both accounts are not tax-deductible and don’t lower your taxable income. With that in mind, one may wonder why bother with them at all? Well, the first thing is you can withdraw your money completely tax-free. It is a huge advantage over a Traditional 401(k) where you eventually have to pay taxes on the whole amount. The second thing is your current and expected marginal tax rate. Before you consider either a Roth 401(k) or a Roth IRA you need to factor your current and expected marginal tax rate. If your current income keeps you in a low tax bracket and you expect your income to be higher at retirement, then contributing to either a Roth 401(k) or a Roth IRA absolutely makes sense.
Let’s take a look at a hypothetical example. Both accounts have a starting balance of $50,000 and grow by 6% per year, for 30 years with a tax rate of 25%. At the end of this period, an owner of the Traditional 401(k) will have to pay 25% in taxes,which will reduce the balance to $215,381. On the other side, with the Roth 401(k) you don’t pay any taxes at all, and can withdraw the whole balance which is $71,794 more. It is a huge difference!
If you expect your tax rate to be even higher at retirement, the Roth 401(k) could be even more beneficial.
Roth 401(k) vs. Roth IRA
Let’s assume that you expect your income and tax rate to be higher at retirement, and realize that Roth contributions are something you need to do. You now face another dilemma, whether to invest in a Roth 401(k) or a Roth IRA. Let’s review both accounts and identify key differences.
|Roth 401(k)||Roth IRA|
|Employer matching contribution||Yes||No|
|Contribution limit||$18,000 + $6,000 catch-up||$5,500 + $1,000 catch-up|
|Contributions subject to income limits||No||Yes|
|Subject to required minimum distributions||Yes||No|
|Recharacterization of rolled-over amounts||No permitted||Permitted|
|Loans||Yes (if plan permits)||No|
|Investment options||Limited by employer||Unlimited|
|Tax-free distributions||Upon attaining age 59.5 if money kept for 5 years||
So Which One to Choose? Do Both!
Unfortunately, there is no “one-size-fits-all” solution and which account is better depends on your current situation and future needs. The key advantages of a Roth 401(k) are:
- High contributions limits (up to $24,000 vs. $6,500 including catch-up contributions)
- If you are a high-earner there are no income restrictions on participation
- Employer’s matching contributions
On the other side, the Roth IRA account also has some valuable features, such as:
- No required minimum distributions which makes it an ideal wealth transfer vehicle
- More investment options, flexibility, and as a result, lower costs
- Easy access to money – you can withdraw your contributions tax- and penalty-free
As you can see, both accounts have valuable features. So, instead of racking your brain over which one to choose, simply do both! You can’t go wrong!