401K plans may now offer an option
to contribute part or all of your annual contributions to a Roth 401K?
The best way to find out if your company offers this new type of
retirement plan is to contact your human resources department and ask if
it is being offered at your place of employment. In general, the same
rules that apply to Roth IRA’s apply to Roth 401K plans.
One of the differences are that you have NO Income limits in the Roth
401K whereas the Roth IRA does, which enables high income earners to
contribute for the first time. But, more importantly, you can contribute
up to $15,000 per year ($20,000 if over 50 years old). A Roth IRA limit
is $5,500 or $6,000 if you are age 50 or older.
Contributions occur after taxes are taken out
in the Roth 401K a well as the Roth IRA but allow for all of the money to be
distributed tax free in retirement. So today you do not get the tax write
off you would get with a 401K but when you retire you get all of it tax free
for life. So, your paycheck would be lessened by the increased amount of
taxes you would now have to pay. If you are young, and earning a decent
wage, you should consider this plan. And if taxes rise in the future to pay
down current debt federal debts, as they surely will, the Roth 401K will
even make more sense even if you are currently in the lower income tax
In addition, once you are in retirement, there is no required distribution
at age 70 ½ as there is in a 401K. You can actually never take the money out
and pass it to your heirs. You cannot do this with a regular 401K plan.
Let’s look at the difference of investing $20,000 into a Roth 401K vs a
regular 401K assuming a 28% tax bracket for this illustration. We invest
$14,400 in the Roth401K and $20,000 in the regular 401k. The reason I am
only showing $14,400 is that we had to deduct the $5,600 in federal tax from
the $20,000 to make the comparison the same. Also, we will assume a similar
8% return in both accounts and the money is invested for 20 years. At the
end of the 20 years, we would show a hypothetical balance of $93,219 in the
regular 401K and only $67,118 in the regular Roth 401K. If the 28% tax rate
is the same at retirement, the regular 401K would yield the same amount as
the Roth 401K which would be $67,118. If tax rates drop to 23% the regular
plan would be worth more at $71,779 but if rates increased to 33% the Roth
401K would win with a balance of $67,118 compared to only $62,457 with the
regular 401K. So, as tax rates rise in the future, the Roth 401K plan
outperforms the regular 401K.
Remember with any Roth account you must hold it for a minimum of 5 years
before it becomes tax free at retirement age of 59 ½. You might also want to
consider putting half of your contributions in the regular 401K and half in
the Roth 401K plan if your retirement plan allows you to do that to hedge
your bet on tax rates in the future.
It is always a good idea to contact a financial advisor to give you the best
possible guidance before you invest.
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