4 Reasons to Consider a Roth 401(k)
January 19, 2016 | Your Finances
When you think about the ways in which you can save for retirement, have you considered a Roth 401(k)?
Roth 401(k)s came onto the market in 2006, and according to the Towers Watson 2014 North American Defined Contribution Plan Sponsor Survey, today more than half (54 percent) of employers currently offer them. Yet only a fraction of employees are taking advantage of them; 8 percent of highly compensated employees (those who made more than $120,000 in 2015) and 11 percent of non-highly compensated employees are currently saving for retirement in a Roth 401(k).
Part of the reason these haven't quite caught on is that most people like to delay paying taxes. When you participate in a traditional 401(k), your contributions are made pretax, which means you delay paying taxes on those dollars until you begin taking withdrawals in retirement. By comparison, when you make a contribution to a Roth 401(k), you pay taxes on that money before you make the contribution, which means your withdrawals (including gains) in retirement will generally be tax free.
So the question becomes this: At some point, you'll have to pay taxes on the money you set aside for retirement. Should you bite the bullet now or bite the bullet later?
It's understandable if your instinct is to delay paying taxes. But if you have access to a Roth 401(k) through your employer, there are five reasons why you may want to consider adding a Roth to your retirement savings plan.
1. You may be in a higher tax bracket in retirement. Many people assume that when they retire and are no longer earning a salary, they'll be in a lower tax bracket; but that's not always the case. And if all of your assets are in a tax-deferred account such as a traditional 401(k), you'll be paying taxes on every dollar that you pull out to fund your retirement. That can be risky for two reasons: You don't know what the tax rates will be by the time you retire, and it's hard to predict the tax bracket you'll be in. You can minimize some of that risk by contributing to a Roth 401(k)—and paying taxes today—on a portion of your future retirement income.
2. The more options you have in retirement, the better. When you have a choice of accounts to draw from in retirement—both taxable and non-taxable—you'll have flexibility to combine various streams of income in a way that allows you to minimize taxes and maximize income. For example, let's say one year in retirement you're inching close to the top of the 25 percent tax bracket, and you want to draw additional income to make a major purchase. If you pull the money from a taxable asset, you may inadvertently bump yourself into the next higher tax bracket—increasing your overall tax liability. But if you could augment your income with tax-free money from a Roth 401(k), you could avoid moving to a higher tax bracket.
3. Unlike the Roth IRA, you can contribute to a Roth 401(k) regardless of how much you earn. Roth IRAs, which have been available for nearly 20 years, impose an income restriction. In 2016, for example, you can contribute the maximum amount to a Roth IRA only if your modified adjusted gross income is $184,000 or less for Married Filing Jointly or $117,000 or less for a Single Head of Household. These restrictions do not apply to the relatively new Roth 401(k), which makes it an attractive option for higher-wage earners.
4. You may be able to avoid having to take required minimum distributions (RMDs) in retirement. With a traditional 401(k), the IRS requires that you take minimum distributions (RMDs) from your account beginning at age 70½ or your retirement, whichever is later. While a Roth 401(k) is subject to these same RMD rules, RMDs can usually be avoided by simply rolling over your Roth 401(k) into a Roth IRA at retirement.
You may be able to convert an existing 401(k) to a Roth 401(k). If you have access to a Roth 401(k), your employer may also offer the option to convert some of your existing traditional 401(k) to a Roth 401(k). You'll have to pay the taxes on whatever amount you convert, but once you convert, your contributions will grow tax free. It's worth considering if you're currently in a lower tax bracket and want to protect existing retirement savings from future tax increases.
For all these reasons, a Roth 401(k) offers benefits worth exploring. By adding a Roth 401(k) to your retirement savings plan, you'll be giving yourself the flexibility to make the most of your money in retirement.