Many people have the option of doing a Roth 401(k) at work. But what exactly is a Roth 401(k), how does it differ from a traditional 401(k) and who should take advantage of one? That’s exactly what we’re going to answer in this article!
Understanding the Roth 401(k)
A Roth 401(k) is a workplace retirement savings plan that has both similarities to and differences from the traditional 401(k) you’re probably familiar with. It also combines features of a traditional 401(k) with those of a Roth IRA.
It’s becoming a popular offering in a larger number of employer retirement plans with more and more businesses starting to offer it.
But where does money expert Clark Howard stand on the idea of doing a Roth 401(k)?
“Doing a Roth 401(k) is vastly superior to doing a traditional 401(k). With a Roth 401(k), you put in money that’s already been taxed into your 401(k) and it’s never taxed again,” Clark says. “If you don’t do a Roth 401(k) at work, then you’re just putting in pre-tax dollars and everything your plan builds to over the years is all subject to tax down the road.”
Comparing the Roth 401(k) to a Traditional 401(k)
We know Roth 401(k)s can seem confusing if you’re not familiar with them. Here’s a look at some of the traits they have in common with traditional 401(k)s:
- The money you contribute comes out of your paycheck before you ever see it
- Eligible for an employer match, if any is offered
- Has the same annual contribution limit as a traditional 401(k)
Meanwhile, there are a couple of key differences between a Roth 401(k) and a traditional 401(k).
- Traditional 401(k) contributions are pre-tax and lower your taxable income today. Then the money is taxed when you withdraw it in retirement. Roth 401(k) contributions, however, are post-tax and therefore don’t lower your taxable income in the present. But the nice thing is the money you contribute won’t be taxed again in retirement.
- The money in a Roth 401(k) can’t be touched until you reach 59 and a half and have had the account for five years, according to IRS.gov. That’s unlike a traditional 401(k), where you can begin to access your money at age 59 and a half with no additional qualifications about the age of the account to meet.
Should I Do a Roth 401(k)?
The question of whether to do a traditional 401(k) or a Roth 401(k) is an easy one in Clark’s book. The money expert says everyone who has access to a Roth 401(k) at work should put all retirement contributions in there rather than a traditional 401(k).
Clark’s reasoning has a lot to do with the likely direction of tax rates in the future.
“The long-term benefit at most brackets is that it’s better having post-tax money that’s already been taxed than pre-tax money that still has to be taxed in retirement,” Clark says.
“Our tax rates today are unusually low because we’re running a massive budget deficit. At some point, those tax rates will increase. That means there’s a good chance tax rates will be higher when you go to spend your nest egg in 25 or 30 years.”
So by doing a Roth 401(k) today, you’re protecting your nest egg against the likelihood of higher tax rates down the road. And that will be a benefit to you when you’re living on a fixed income.
Roth 401(k)s are becoming more widely available today than ever before. If you have access to one at work, you should be funding it to the max to ensure your future financial security. That’s unless, of course, you’re a very high income earner. In that case, you’d want the pre-tax contribution benefit of a traditional 401(k) to lower your taxable income today.
Unfortunately, only a minority of American workers are taking advantage of the benefits of a Roth 401(k).
“Almost nobody does a Roth 401(k), which is a big mistake,” Clark says. “Most people will benefit significantly more doing a Roth 401(k) than a regular 401(k), particularly when you’re earning a more modest salary in the early part of your career.”