Employers are increasingly offering a Roth 401(k) option in their retirement plan. Half of employers now provide employees with a Roth 401(k) plan, up significantly from 11 percent in 2007, according to an Aon Hewitt survey. Employees at these firms get to choose whether to pay tax on their retirement savings up front or during withdrawal. But only 11 percent of eligible workers opt into the Roth.
With a traditional 401(k) plan, you contribute to the account on a pre-tax basis. That means you will get a tax break up front, but you will have to pay tax when you withdraw the money. In contrast, you contribute to a Roth 401(k) after paying tax. The big benefit is that the money in your Roth 401(k) will be tax-free when you take distributions in retirement. Roth 401(k)s also have other perks including additional flexibility in retirement. Here’s how to decide if it’s worth your time to log into your 401(k) account to make the change:
Tax diversification. Having a tax-free income source is a great tool in retirement. Most people will have multiple sources of retirement income such as a Social Security benefit, traditional 401(k) withdrawals and investment income from your taxable brokerage account. All of this taxable income can push you higher in the tax bracket and will affect how your Social Security benefit is taxed. More income can lead to a greater percentage of your Social Security benefit being taxed. You can keep your overall taxable income down by withdrawing some funds from your traditional 401(k) and some funds from a Roth. This can help you avoid a higher tax bracket and lower your overall tax liability. Having some retirement money in a Roth account will give you this flexibility in retirement.
No required minimum distributions. When you reach age 70 1/2, you will need to start taking withdrawals from your traditional 401(k)s and IRAs. Even if you don’t need the income immediately, you still need to take a distribution each year and pay tax on it. Roth accounts do not require withdrawals in retirement, and can also be passed on to heirs.
Employer matching goes in the traditional 401(k). It’s important to take full advantage of the employer match part of your 401(k) contribution if this is available. It’s the easiest money you will ever make. The company contribution is pre-tax and will go in your traditional 401(k). So by contributing to the Roth 401(k), you will have some funds in the tax-free bucket and some in the pre-tax bucket. It’s good to have more choices when it’s time to take withdrawals so you can minimize your tax liability.
Save more. The 2014 annual contribution limit for 401(k)s is $17,500 for those under 50. If you are 50 or older, you can contribute an additional catch-up amount of $5,500. These contribution limits apply to both the traditional and Roth 401(k). However, a dollar in a Roth 401(k) is more valuable than a dollar in a traditional 401(k) because the funds in your Roth 401(k) plan won’t be taxed when you take a distribution. So for investors who want to save more in their tax-advantaged account, the Roth 401(k) is the way to do it. Paying tax up front is a little painful, but you’ll ultimately end up with more money in retirement.
Consider a Roth 401(k). Taxes are one of the biggest expenses we have, and it’s worth our time to plan for it. Investing in a Roth 401(k) and Roth IRA will give you a big tool to help minimize your tax liability in retirement. It’s best to have assets in pre-tax, tax-free and low tax (capital gain and dividend) accounts. The Roth 401(k) is particularly suited for young people who are in a lower tax bracket and have a lot of working years left ahead of them. A Roth 401(k) can then grow tax-free and compound over many years. But the Roth 401(k) is also a great tool for older workers who want to avoid a large tax bill in retirement.
Joe Udo is a stay at home dad who blogs at Retire by 40.
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4 Reasons to Save in a Roth 401(k) originally appeared on usnews.com
