Since the downturn in 2008 and the bankruptcy of General Motors in 2009, many employers have discontinued defined benefit plans – commonly referred to as pensions. Many have either discontinued the plans or have frozen them as “cost saving” measures. Others have replaced these costlier plans with the less expensive 401k plans. A 401k is a way for employers to put money into a retirement plan, but only if the employee also contributes to the plan. These contributions are often referred to as “matching contributions” and come in all shapes and sizes. Some forward-thinking employers have also added a very valuable feature to their 401K plans called a “Roth 401k” Option.
Since January 1, 2006, laws have been changed to allow 401k plans to amend agreements to allow for Roth IRA type tax treatment for a portion of or all retirement plan contributions.* This Roth IRA tax treatment allows employees to contribute a portion of their paychecks on an after-tax basis, which allows those contributions to grow, tax-free, for retirement. The law also provides the option for the employer to match these contributions. However, the match cannot go into the Roth 401k side of the plan – only into the traditional 401k side of the plan that will grow tax deferred for retirement. This means the employer match will grow for the future, but when you take that portion out for retirement, you will owe tax on all withdrawals.
So you may be asking, “Should I be making contributions to a Roth 401k or the traditional 401k?” It depends. Potential Roth 401k candidates are income earners who are near the start of their career, and believe they will be in a higher tax bracket during retirement than they are right now. Another consideration is for those who believe tax rates will be considerably higher in the future. With the amount of debt the U.S. is carrying, I think there is a good possibility tax rates could be almost double what they are now at some point in my lifetime. If this happens, a Roth 401K could perhaps become the most valuable planning tool available.
There are a few other considerations when comparing a Roth IRA to a Roth 401k.
- A Roth IRA has limitations as to how much money someone can make and still contribute. The Roth 401k has no income-based limitation.
- A Roth IRA also limits the amount that can be put into the IRA – a $5,500 annual maximum. With the Roth 401k the limitation is $18,000.
- A Roth 401k can be rolled over upon termination of employment into a Roth IRA, which provides flexibility if cash needs to be available.
If your employer offers a Roth 401k option, it may be a viable savings tool for your future. If your employer matches, that portion would go into the traditional 401k plan; but you would then have two potential pools of money to draw from during retirement. One pool would be taxable, one would be tax-free, as long as you’ve had the plan for five years and reached the minimum age of 59.5 years.
If you are wondering about contributing to a Roth 401k, we would be happy to provide a free consultation. If you have a financial advisor, be sure to have a conversation together or speak with a tax advisor.
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