With the new year often comes new retirement-savings options at workplaces around the country, including, at some, the Roth 401(k). Questions typically follow.
In a Roth 401(k), income is invested in a retirement-savings account after taxes have been taken out, instead of before as with a traditional 401(k). The main benefit is that once the investor turns 59½, distributions from a Roth 401(k) are tax-free, including any investment gains, as are those in Roth IRAs. With a traditional 401(k), distributions after age 59½ are taxed as regular income.
One important consideration for older workers considering a Roth 401(k): For distributions to be tax-free after age 59½, the investor must have had the Roth 401(k) for at least five years.
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Employers typically offer the same investment options in Roth and traditional 401(k) plans and allow employees to invest in both simultaneously, so long as their total annual contributions don’t exceed the Internal Revenue Service’s limit, which in 2020 is $19,500, or $26,000 for workers ages 50 and older. If an employer matches a portion of contributions to a Roth 401(k), then that company match is placed in a traditional 401(k), and any withdrawals are subject to taxes.
“A lot of employers are enacting it because employees are asking for it and saying, ‘Why isn’t it available in my plan when I know it’s available in other people’s plans?’ ” said Chris Powers, senior vice president and managing director of financial planning at Girard in King of Prussia, Pa.
So, which way should you go if you have the Roth 401(k) option?
Ken Moraif, senior retirement planner at Retirement Planners of America in Dallas, said workers considering a Roth 401(k) should start with a simple question: Will you be in a higher tax bracket in the future than you are today? If the answer is yes, then the Roth 401(k) is a good option. If the answer is no, then stick with a traditional 401(k), he said.
But there are many reasons why a retirement saver might choose the Roth route over the traditional 401(k). Maybe you want to leave money to your family tax-free when you die. Maybe you believe that higher income-tax rates are inevitable. Or maybe you make too much money to qualify for a Roth IRA, which phases out for married households with incomes above $196,000.
“For high earners, it’s a good option because that’s the only way they can get money into a Roth,” Powers said.
One big selling point is that beneficiaries of a Roth 401(k) inherit the money tax-free, unlike with a traditional 401(k). “If you’re really looking to leave a legacy to the next generation, then you want to lower the tax burden as much as possible,” Powers said.
There are trade-offs in other areas. By investing in a Roth 401(k), employees potentially are missing out on an immediate tax benefit of a traditional 401(k). Contributions to a traditional 401(k) lower a worker’s adjusted gross income, reducing the employee’s tax liability.
In addition, employees who invest solely in a traditional 401(k) will have more money invested during their working years since contributions went in tax-free. For younger workers, the additional investment gains in a traditional 401(k) could be substantial in their retirement years and could possibly offset the tax-free-distribution advantage of Roth 401(k) investments.
“If you’re not sure which way to go, you can split your contributions between the Roth and the traditional 401(k) and invest a certain percentage in each,” Powers said.
Here are some other important characteristics of Roth 401(k) plans:
• Since distributions aren’t taxable, they won’t push retirees into higher tax brackets, and they don’t increase Medicare Part B premiums or the taxes paid on Social Security benefits.
• In most cases, employees can convert their vested contributions from their traditional 401(k) plans into a Roth 401(k), though they will be taxed on those funds. This is similar to converting funds to a Roth IRA from a traditional IRA. Powers said employees with variable compensation, such as salespeople or those with bonuses, should try to make conversions during a year when they are earning comparatively little money.
• Distributions before age 59½ due to disability or death are tax-free, as with a traditional 401(k).
• If you need to withdraw money from your Roth 401(k) early, you will need to pay taxes and likely a 10% penalty on the portion of the withdrawal that comes from investment gains. Your contributions, which went in after taxes were taken out, may be withdrawn without penalty.
Early distributions are prorated between contributions and earnings. For example, if an investor has $50,000 in a Roth 401(k)—$40,000 from contributions and $10,000 from investment gains—then any withdrawal would be made up of 80% contributions and 20% gains. Therefore, withdrawing $10,000 would mean paying taxes and likely a 10% early-withdrawal penalty on $2,000.
• Roth 401(k) accounts are subject to required minimum distributions once the investor reaches age 70½, just like traditional 401(k) accounts. In both cases, investors can avoid taking RMDs by converting funds to a Roth IRA.
Questions? Comments? Write to us at retirement@barrons.com
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January 25, 2020 at 08:00PM
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Roth 401(k) or Traditional 401(k)? How to Know What’s Your Best Option. - Barron's
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