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“Say Hello to my Little Friend”: the Roth 401(k)

By Nick Loring, CFP®, MBA, CRPC®, CRPS®

It’s not quite what Tony Montana had in mind when he said one of the most memorable quotes in the movie Scarface, but since its inception in 2006, Roth 401(k) plans have increased in popularity, with more and more employers offering them to their employees. Many people don’t realize that they’re available in their retirement plans, or if they do, don’t understand how it works and are reluctant to contribute. Are you missing out? (This article specifically mentions 401(k) plans, but many 403(b) non-profit plans or 457 governmental plans have Roth components too. The general guidelines for the Roth 401(k) will apply to these as well.)

Let’s start with understanding some basic differences between the Traditional 401(k) and Roth 401(k). With your Traditional 401(k), you make pre-tax contributions to the plan. Any amount that you contribute will lower your gross income for that given year. When you retire and start to take withdrawals from the contributions and investment growth, you pay income taxes on that amount, based on your income tax rate for the year of withdrawal. Withdrawals before age 59 ½ can result in an additional 10% penalty with certain exceptions.

With your Roth 401(k), it is an after-tax contribution to the plan. You do not get any income tax benefit for the year in which you contribute; the amount contributed is included in your gross income for the year. As long as you have your Roth 401(k) open for 5 years and are over the age of 59 ½, you will pay no income taxes on ANY of the investment growth or withdrawals from the account (the 10% penalty can still apply if the criteria is not met). To make it simpler, think of it this way: Traditional is taxed on distribution, Roth on contribution.

Both are similar in the fact that contribution limits are the same for both plans for 2016, ($18,000 age 49 & younger, $24,000 for age 50 & older) and you can contribute to both the Traditional and Roth 401(k) at the same time. Any employer match to a Roth is done in pre-tax dollars and kept separate, so you may pay income taxes on those withdrawals in the future. You can usually convert your Traditional 401(k) to a Roth at any time, but you cannot convert a Roth 401(k) to a Traditional.

Many people confuse the Roth 401(k) and Roth IRA, but they have differences too. Most notably, you can only contribute $5,500 ($6,500 age 50 & up) to a Roth IRA. There are no income limitations to contribute to a Roth 401(k), whereas if you’re a single filer whose income exceeds $132,000, or $194,000 if married filing jointly, than you cannot contribute to a Roth IRA. The Roth 401(k) is subject to the age 70 ½ Required Minimum Distribution Rule, like a Traditional 401(k) and Traditional IRAs, where Roth IRAs have no mandatory distributions whatsoever.

So when does it make sense to contribute to a Roth 401(k)? The best instances are young workers whose income isn’t very high and have a low tax rate. There are minimal taxes paid now to have many years of tax-free investment growth. Also if you expect your tax rate to be higher in retirement than while working, regardless of age, contributing to a Roth 401(k) would be an effective strategy. Contributing to a Roth 401(k) can also offer flexibility in retirement as well – $30,000 for new car purchase if taken out of the Traditional 401(k) can add 20%-30% to the total cost of the car when you factor in the tax liability. Withdrawing these funds from a Roth 401(k) would be tax-free, and potentially save you from increasing your marginal tax rate.

There are times when the Traditional 401(k) makes sense too. If you’re older, in your peak earning years, with a high tax rate, it’s usually more effective to defer paying taxes on that income until retirement. Additionally, contributions to the Traditional 401(k) reduce your gross income, which may mean you can qualify for Roth IRA or spousal IRA contributions, or if your income is low enough, things like student loan interest deductions or the Earned Income Tax Credit. Lastly, people can typically afford to contribute more to a Traditional 401(k) than a Roth 401(k). A $250 per month after tax contribution to a Roth 401(k) works out to be approximately a $357 pretax contribution to a Traditional 401(k) (assuming a 25% federal tax rate and a 4.99% state rate). With the larger contributions and anticipated compounded growth, you would have a larger pot of dollars in a Traditional 401(k) than a Roth 401(k) if similarly invested over the same period of time.

So which one should you contribute to? For everyone it’s different. Projections on your income in retirement, your future earning potential, and any changes to tax laws are all speculative and hard to predict accurately. Consult with your tax or financial advisor to help you develop a contribution strategy that makes sense for your particular situation. To maintain maximum flexibility of your finances in the future, it could be best to take advantage of both, but a contribution to either one will put you on the right path to a successful retirement. As Tony would say,” In this country, you gotta make the money first. Then when you get the money, put it in your 401(k)…” or something like that.

Nick Loring CFP®, MBA, CRPC®, CRPS® is a financial advisor located at Loring Advisory Group, 600 Putnam Pike, Suite 4, Greenville, RI 02828. He offers securities and advisory services as an Investment Adviser Representative of Commonwealth Financial Network®, Member FINRA/SIPC, a Registered Investment Adviser. He can be reached at (401) 949-4196 or at nick@loringadvice.com.