Should You Switch to a Roth 401K?

The Roth 401K was introduced in 2006 as a counterpart to the Roth IRA. It was originally set to sunset in 2010, so most employers chose not to offer it. The sunset provision has been removed, so many employers are offering them this year. If your employer offers it, you should seriously consider switching into it. If your employer doesn’t offer it, campaign for it! It really is that good.

What a Roth 401K Is

A Roth 401K is a retirement account similar to a traditional 401K in that your employer sets up the plan and takes contributions from your paycheck. If your employer provides a 401K match, they can continue to do so, but must put matching contributions in a pre-tax account. You can typically invest in the same selection of mutual funds as your traditional 401K. Contributions remain the same: $16,500 for 2010, plus an extra $5,000 contribution for employees over age 55. Unlike the Roth IRA, there are no income limitations on Roth 401K eligibility.

If you open a Roth 401K and then switch jobs, you can either roll the funds into a new Roth 401K with your new employer or open a Roth IRA. There are no income limitations if you open the account for a Roth 401K rollover.

How a Roth 401K Differs from a Traditional 401K

There are a few key differences between the two plans:

The Roth 401K uses post-tax dollars.

That means that your contributions don’t reduce your taxable income. If you contribute $50 per paycheck, your paycheck will be reduced by $50 and your taxes will be slightly higher than they were before.

Roth 401K retirement withdrawals are tax-free.

All withdrawals – even the gains. If you withdraw $50,000 a year to live on, that’s exactly how much you have to live on. You don’t have to worry about setting some aside for taxes. Of course, there are two stipulations: you must be 59 ½ and the account must have been open for five years in order to receive the money tax-free. Since this is a retirement plan, that shouldn’t be a problem for you.

You can avoid required minimum distributions.

Both traditional and Roth 401Ks require you to start withdrawing your savings at age 70 ½, but there’s a loophole for the Roth 401K. You can rollover your funds into a Roth IRA before the initial required minimum distribution and avoid it! Roth IRAs don’t have RMDs.

The Advantages of a Roth 401K

Even if you currently have a high tax rate, there are still advantages to choosing a Roth 401K and paying the taxes on your contributions now. First, tax rates will be going up. (Argue all you want, but most advisers agree on this point.) If you pay the taxes now, at least you know what you’re getting into.

Second, the growth is also tax-free with the Roth. Here’s a scenario: you put $1,000 in now and pay $250ish in taxes on that income. That money grows to $10,000 by the time you retire (totally making up numbers here.) If you have a traditional 401K, you’ll save the $250 on your taxes now, but owe $1,000 in taxes in retirement (assuming the 10% tax bracket at retirement.) If you have a Roth 401K, you’ll only ever pay $250 in taxes. Unless you lose a greater portion of your investment than you contributed, the Roth 401K will save you money in the long-run.

Third, not owing taxes makes it easier to plan your retirement budget. You don’t have to set aside money for taxes. Just withdraw the money and spend it as needed.

Converting to a Roth 401K

The easiest way to switch to a Roth 401K is to redirect your current contributions to the new plan. Ask your benefits administrator for the form. You can also convert your current 401K funds until the Roth 401K, but you’ll have to pay the taxes on that money. You should avoid using retirement funds to pay those taxes, so you should only convert if you have money for the taxes in savings. If you decide to convert your current account, that tax will be paid over two years. You don’t have to pay it all this year.

If this plan is available to you, you should seriously consider it. It will save you a LOT of money in the long-run, even if it costs you a little more right now.

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