What is a Roth 401k?
As you probably guessed, a Roth 401k is simply a 401k account that is treated, from a tax sense, like a Roth IRA. The word “Roth” comes from William V. Roth Jr., a Delaware senator who pushed for the creation of these kinds of accounts.
With a regular 401k account, 401k contributions are deducted from an employee’s wages. Later, when the employee retires and takes money out of their retirement account (which could be in a traditional IRA by then), the U.S. government will tax the distribution as income. With a Roth 401k, the employee essentially pays the tax up front because they chose not to deduct it from their wages. It basically comes down to whether you want to be taxed now, or taxed later.
Roth 401k vs. Regular 401(k)
Which is better? As with Roth vs. Regular IRAs, it depends on your situation. Keep in mind, you may not even have a choice yet because Roth 401ks are new enough that your employer may not offer them yet. Assuming you have this as an option or will in the future, let’s take a look at some general guidelines of which situations seem to work better for the Roth 401k product.
A Roth 401k works best if:
- You are in a lower tax bracket (if you are at a lower tax rate than you expect in retirement, then you can take advantage of it now).
- You are a young investor (more time for your account to grow and compound tax-free).
- The government increases tax rates over time.
- You want to diversify your tax situation by giving yourself the option to draw from your Roth account or your traditional account, depending on your situation each year in retirement.
- You are a high-wage earner who is blocked from Roth IRAs (the Roth 401k doesn’t have the tax limits a Roth IRA does).
- The mutual funds held in your Roth 401k experience significant gains.
Word of Caution
Avoid the Roth 401k if you have less than 5 year to retirement. If distributions are made before the 5-year gap, it becomes an unqualified distribution, meaning it is subject to taxes. Also be aware that company matching will go into a traditional 401k account due to regulations.
Sunsets and Limits
There seems to be a little confusion over Roth 401ks and Roth IRAs. In 2010, the laws that allow these two types of investments will be up for renewal. If congress doesn’t extend the laws, you will not be able to continue contributing to these accounts. It doesn’t mean you will lose the money or be taxed on the accounts, it simply means you will be forced to use the traditional versions for new contributions beyond 2010.
As for limits, the government finally made it easy on us. Roth 401k contribution limits are the same as regular 401k contribution limits.
