Pros & Cons of Roth 401(k)s
What if your employer offers a Roth 401(k), alongside normal 401(k) plans? Should you take it? Although Roth 401(k)s aren’t for everyone, they work best if you can afford to pay taxes on contributions now and expect tax rates to rise in the future.
When you direct a portion of your salary into a Roth 401(k), you pay tax on the deferred salary just as if you received it in cash. This deferred salary can be subject to ordinary income tax, as well as Medicare and Social Security withholding.
The unique thing about your Roth funds is that upon withdrawal, if you reach a threshold, such as age 59½, the growth in the account is no longer subject to tax. The same type of tax treatment is applied to a Roth individual retirement account. Conversely, the regular 401(k) growth and contributions are subject to ordinary income tax upon withdrawal – just the same as a non-Roth IRA.
Pros of a Roth 401(k) versus a regular 401(k):
· Future taxation is eliminated. Growth and contributions are tax-free when you withdraw them after age 59½.
· No need to be concerned over future tax rates since you already paid the tax on your contributions. If future tax rates are greater, you pay the higher rates on regular 401(k) distributions – no tax is due on qualified Roth 401(k) distributions.
· You can withdraw the money tax-free with restrictions, prior to age 59½ – as long as you already left the employer associated with that account.
· Early distribution options for education, home down payments or medical expenses are not available for a Roth, as they are from a regular 401(k). So you are not tempted to use the Roth as emergency money.
Benefits of a Roth 401(k) versus a Roth IRA:
· The Roth 401(k) allows higher contribution amounts – up to $23,000 in 2013, compared to $6,500 for a Roth IRA. The 401(k) maximum is $17,500 – and $5,500 in catch-up contributions (extra allowable money from people over 50).
· Employer matching contributions are available for a Roth 401(k), but can only be deposited into a regular 401(k).
· Income restrictions applied to Roth IRA contributions are mostly eliminated with the Roth 401(k). Married couples making more than $183,000 yearly, for instance, are ineligible for a Roth IRA.
· Contributions can be made to the Roth 401(k) account after you reach age 70½ if you are still working and you don’t own more than 5% of your company.
· You can take out a loan against the balance in the Roth 401(k) account while still employed, if allowed by the plan administrator.
Cons of a Roth 401(k)
Negative aspects of a Roth 401(k) compared to a regular 401(k):
· You pay tax on the salary deferred into the Roth 401(k), whereas deferrals to a regular 401(k) are not subject to ordinary income tax.
· If tax rates are lower for you in retirement, you already paid a higher rate on the contributions to the account, although the growth is still tax-free for qualified withdrawals.
When comparing a Roth 401(k) to a Roth IRA, the following downsides are evident:
· Upon reaching age 70½ your Roth 401(k) account is subject to required minimum distributions, just like a regular 401(k) or IRA. You can mitigate this by rolling over the Roth 401(k) to a Roth IRA – which doesn’t require you to start taking money out at 70½ – when you leave your employer.
· You can’t access the contributions to the Roth 401(k) before you leave your company, while you always have access to the contributions to a Roth IRA.
Decision Point
The decision whether to participate in a Roth 401(k) is primarily the same as deciding between a Roth IRA and a regular IRA. But the decision between the two types of IRA is a bit more complicated due to restrictions on income levels and deductibility that don’t apply here. The question comes down to whether you can afford the tax on the maximum contribution to a Roth 401(k) and whether you think the tax rates are going higher or lower before you reach retirement age.
Affordability
If you can’t afford to pay the additional tax on the deferred salary, as compared to when you place the money in a regular 401(k), then it is better to choose the regular 401(k).
For example, if you’re in the 25% tax bracket, deferring the maximum $23,000 into a regular 401(k) reduces your taxes by $5,750. If you chose the Roth 401(k) instead, you’d have to pay that much more in tax. If this additional tax makes it harder to pay your daily expenses, the Roth 401(k) is not a good option for you.
Keep in mind that the decision isn’t all-or-nothing: You could choose to direct a portion of your deferral to Roth 401(k) and the remainder to the regular 401(k) to manage the extra tax.
Future Tax Rates
If you believe that the future tax rates will be higher than they are for you now, it is to your advantage to use the Roth 401(k). It allows you to pay tax at today’s lower rate and avoid the higher future rate. On the other hand, if you believe that the rates will drop for you in the future, deferring tax with non-Roth 401(k) contributions is a better idea.
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Jim Blankenship, CFP, EA, is an independent, fee-only financial planner at Blankenship Financial Planning in New Berlin, Ill. He is the author of An IRA Owner’s Manual and A Social Security Owner’s Manual. His blog is Getting Your Financial Ducks In A Row, where he writes regularly about taxes, retirement savings and Social Security.
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