Overview of Roth 401k

Some Details on the Roth 401k

401K
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Roth 401k is an option in some company retirement plans. It allows employees to contribute “after-tax” money to the plan (from their salary). The idea – if all goes well and you follow all of the IRS rules – is that you can prepay your taxes and avoid paying taxes when you take the money out in retirement.

If you’re familiar with traditional 401k contributions, it might help to compare and contrast.

For decades, 401k plans allowed pre-tax (or traditional) contributions to the plan. Those contributions reduced your taxable income, which might make it easier to contribute (or might help you pay at a lower rate, if you ended up in a lower bracket at retirement). However, because that traditional money has never been taxed, the IRS requires you to pay tax on all money taken out of traditional accounts (presumably you’ll do this in retirement, although you might withdraw early – which could result in additional taxes and penalties).

In 2006, the laws changed to allow Roth 401k contributions. Like traditional contributions, Roth contributions come out of your salary. However, they don’t reduce your taxable income. You’ll pay roughly the same income tax whether you put the money in Roth 401k or you deposit the funds to your bank account.

As with most retirement accounts, you don’t have to pay taxes on earnings inside of the account every year.

Roth 401k Limits

The limits for Roth 401k contributions are the same as for traditional 401k contributions. In 2016, the maximum you can contribute to a 401k (as salary deferral) is $18,000. You can do all of that as Roth, all of it as traditional, or you can do a portion of each. If you’re over the age of 50, you can contribute an additional $6,000 per year.

Employee vs. Employer Dollars

When you direct part of your salary to a 401k, you’re making “salary deferral” contributions (which are also referred to as “employee” contributions), and you can choose whether you want to make traditional, Roth, or both types of contributions. Your employer might also contribute to the plan and help you build up your retirement savings. Those contributions (which might be matching contributions or profit sharing contributions) are referred to as employer contributions. Employer contributions will generally be “pre-tax” contributions into your account.

Does it Make Sense to use Roth?

Roth 401k is simply an option, and it might or might not be the best option. Speak with your tax preparer or a qualified tax advisor before making your decision.

If you believe that income tax rates will go up in the future, Roth might be a good idea. That could happen due to across-the-board tax rate increases (in other words, at the same level of income, you’d pay taxes at a higher rate in 15 years), or due to your moving up in the tax brackets.

Traditionally, the assumption was that you’ll be in a lower tax bracket in retirement: you’d stop earning income from your job, and you’d have a relatively small income from Social Security (and maybe a pension).

If that holds true, Roth could end up being the wrong move. But even then, it’s not so simple – the world is a complicated place. The type of account you use could affect how much income you show on tax returns, which could affect other things.

We can never know what will happen, so you have to make some assumptions and educated guesses. If you’re not confident one way or the other, you can always spread the money around: make some traditional contributions and some Roth contributions. That way, you’ll have the option to pull from whichever account works best for you at that time.

Important: the information on this site is provided for discussion purposes only. It should not be used to make important financial decisions that could have expensive consequences. Consult with a qualified professional with knowledge of your situation before making any decisions.