The Basics of a Roth 401(k)

By Barry Solomon , last updated July 9, 2011

A Roth 401K combines the features of a Roth IRA and a regular 401K plan. Primarily, contributions to the Roth 401K are made with after tax dollars. As a result, withdrawals from the Roth 401K, as long as they are made after the plan owner turns fifty-nine and a half years old and the plan has been in place for at least five years, are not subject to income tax. Of course this means that you are sacrificing the up front tax deduction of a regular 401K and, as a result, you will have effectively reduced your take home pay for the years in which you make contributions. Ini a regular 401K or IRA, contributions are made with pre-tax dollars so that subsequent withdrawals will be subject to income tax.

This creates an advantage to high income individuals who have been unable to contribute to a Roth IRA because of income restrictions. In any year that you make over $105,000 as a single tax payer or $177,000 as a joint tax payer, you cannot make contributions to a Roth IRA. There are no such income restrictions for a Roth 401k's, however, have limitations as to how much you can contribute in a given year. It is $16,500 for those under the age of 50 and $22,000 for those 50 or older. The Roth IRA limits are just $5,000 for those under 50 and $6,000 annually for those 50 and over. And you can't circumvent the limits by having both a regular and a Roth 401K. You can contribute to both but you cannot exceed the combined limit.

Deciding between a regular 401K and a Roth 401K is primarily a tax rate consideration. If you believe that your tax rate will remain the same or even increase upon retirement, then you should take the Roth 401K and pay taxes on the money now at a lower rate. Conversely, if you feel that your tax rate will decrease with retirement, then you are better of using pre-tax dollars to fund a regular 401K and pay the taxes at the lower rate as you withdraw the money from your plan. While no one has the proverbial crystal ball, when you consider that there is a huge deficit to be paid off and that funds will have to be raised to keep Social Security and Medicare viable, it is likely that the tax rate will increase in the future to cover these huge expenditures. This reasoning mitigates in favor of the Roth 401K.

You are eligible for a Roth 401K as long as your company decides to offer it. Employers have concerns about the costs involved in managing this type of plan and educating their workers about this as an investment option. Generally businesses will offer the plan if their employees request it in sufficient numbers. And if your employer matches your contributions, know that they are doing so with pre-tax dollars so that even though this is a Roth plan, that portion of your pension withdrawal will be subject to regular income taxes. And if you do leave your job, your Roth 401K can be rolled over into a Roth IRA.

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