Four things you need to know about Roth 401(k)’s
When I posted recently on how to choose whether to fund your 401(k), Roth, or traditional IRA, I forgot to mention another category: the Roth 401(k). The Roth 401(k) rocks. Like a Roth IRA, you put money in post-tax but then (in retirement) you take out the funds (plus appreciation!) without tax. Unlike a Roth IRA, there is no income limit to be eligible to contribute. For a Roth IRA, contribution eligibility phaseouts begin (for 2009) at $105k for singles and $166k for married folk. Only about 20% of employers’ 401(k) plans offer the Roth option, but the percentage is growing.
If your employer offers a both a 401(k) and a Roth 401(k) and matches both, you might consider dividing your contribution equally between the two, to hedge against future changes in your tax rate. Your tax rate might change if you make a lot more (or less) money or because Uncle Sam decides to change the rules. Either way, it’s a good idea not to have all your eggs in one basket.
The Roth 401(k)is especially good if you’re just getting started in the business world, and you’re in a relatively low tax bracket. According to the Financial Planning website InvestmentNews, the highest rate of participation in Roth 401(k)’s is by young workers under 25.
Four things you need to know about Roth 401(k)’s:
1) There is no income limit to participate (unlike Roth IRA’s.)
2) Your contribution is taxed. For example, let’s say you make $100k and contribute 10% to your retirement. You decide to put half into a conventional 401(k) and the other half in a Roth 401(k). Your employer will put $5k of your money into the 401(k) and $5k of your money into the Roth 401(k). At the end of the year, your W-2 will show $95k for income for that year. The $5k that went into the conventional 401(k) is not taxed this year; it will be taxed when you withdraw it (and accumulated gains) during retirement. If you choose to put all of your contribution into a conventional 401(k), then your W-2 would show only $90k for the year. Conversely, if you choose to put all of your contribution into a Roth 401(k), then your W-2 will show the full $100k.
3) If your company matches your Roth 401(k) contribution, any company match goes into a conventional 401(k) — not the Roth. By law, the match cannot receive the favorable tax treatment.
4) When you leave your job, you can move the Roth 401(k) into a Roth IRA. You can also move your non-Roth 401(k) into a traditional IRA. You cannot move a Roth 401(k) into a traditional IRA or a traditional 401(k) into a Roth IRA; the pre-tax and post-tax funds must always be kept separate. Moving from a 401(k) into an IRA is usually a good idea, as it opens up additional investment choices.
Since the Roth 401(k) contribution amount is post-tax, if you redirect your 401(k) to go into a Roth 401(k), you’ll have less to spend each month. To neutralize this effect, you can reduce the amount you put into your Roth account by a ratio that reflects the tax. For example, let’s assume an employee makes $100k and wants to put 10% of his total pay towards retirement. To hedge against future tax changes, he decides to put 50% of the retirement money towards a 401(k) and 50% towards a Roth 401(k). He is in the 25% marginal tax bracket. He can put half the $10k (which is $5k) into the traditional 401(k). For the Roth 401(k), he will contribute $5k * (1-tax_rate) = $5k * 75% = $3750, leaving $1250 for income tax.
Balancing your 401(k) and Roth 401(k) is a good way to hedge against future changes in tax rates. Funding both types of accounts provides a buffer against the vagaries of the tax code.
IRS Publication 4530: Designated Roth Accounts under a 401(k) or 403(b) Plan
By day, Helen engineers new materials to make computer chips cheaper, better, and faster. When the son goes down (pun intended), she writes about personal finance at Affine Financial Services.