Roth 401K Basics
The invest in a Roth IRA or 401K post from last week triggered a number of questions from readers. I wanted to highlight and discuss one of them, in particular.
It comes from reader, Sandi, who writes in,
“I just started a new job and in 3 months I’ll have to decide between a regular 401K or a Roth 401K. The employer contributes 5% salary to either. I’d never even heard of a Roth 401K before. What are the major differences? Are there more benefits to one over the other?”
Great question, Sandi!
I believe that the choice between an IRA and 401K is pretty clear cut. However, the choice between a Roth retirement account and a traditional retirement account is always much more subjective.
I’ll discuss what considerations should go into the decision right after covering the basics.
What is a Roth 401K?
Roth 401K’s are relatively new in the world of retirement accounts. They were first introduced in the United States in 2006, but their adoption has been a little slower. According to U.S. News, only 29% of companies in the U.S. have the Roth 401K option. If you do, consider yourself lucky.
A Roth 401K combines many of the benefits of the Roth IRA and the Traditional 401K.
You have the same 401K maximum contribution as a Traditional 401K while still having the tax now/no tax in retirement benefits of a Roth IRA.
Still, there are some important distinctions to be made and a Roth 401K might not be the best for everyone.
Are Roth 401K Matching Contribution Tax Free?
This thought crossed my mind a few years ago when I found out my employer was adding a Roth 401K option: “Wow, I can get post-tax matching contributions to a Roth 401K! More free 401K match dollars!
It’s probably the most common Roth 401K misconception there is.
Unfortunately, Roth 401K matching funds are not post-tax dollars.
When you open a Roth 401K, your employer will open a separate traditional 401K. All matching funds that go into that traditional 401K are pre-taxed, meaning that you are not taxed now, but you are taxed on withdrawals in retirement.
What is the Maximum Employee and Employer Roth 401K Contribution?
Same as the Traditional 401K, the maximum Roth 401K contribution for employees is $17,500 in 2014, or $23,000 for those 50 and over.
The maximum employer contribution for a Roth 401K is also the same as the traditional – $52,000 (combined with employee contribution) or 100% of the employee’s salary (whichever is less).
Roth 401K or Traditional 401K?
Getting back to the original question, there is no right answer on the Roth vs. Traditional 401K question.
Many financial pundits recommend young professionals go with the Roth because they claim you’ll be in a lower tax bracket now than when you are in retirement due to lower earning power now. As such, they argue that it’s to your benefit to get taxed now (Roth) vs. being taxed in retirement (Traditional).
Sounds great in theory, however, I think it’s a flawed argument.
There is an assumption that you will have so much saved for retirement that you’ll actually be earning more income on your retirement account withdrawals than the income you are making right now. That’s not always going to be the case. In fact, for many, the opposite will be true. Painting broad brush statements like that are dangerous.
Others argue that tax rates will only go up in the future, so you might as well pay lower taxes now. This is another dangerous assumption to make. Short-term budget shortfalls may fuel this thought. However, when you look at the historical income tax rate, taxes are near the lowest point since 1931! The long-term trend has been downward, even with a little bump in the last few years to the top tax bracket. And with one political party making it their entire platform, that may never change.
Roth 401K vs. Traditional 401K Chart (2014)
|Roth 401K||Traditional 401K|
|Can be Started By||Employer only||Employer only|
|Matching Funds Are||Pre-Taxed in a Traditional 401K||Pre-Taxed in a Traditional 401K|
|Maximum Annual Individual Contribution (2013)||$17,500 (2014)||$17,500 (2014)|
|Catch-up Contribution for those over 50||$5,500||$5,500|
|Can Roll-Over to||Roth IRA or new employer's 401K||Traditional IRA, a new employer's Traditional 401K, or a Roth IRA (pay taxes)|
|Pay Taxes At||Time of Contribution||Withdrawal in Retirement|
|Can Begin Withdrawing Earnings Without Penalty||At age 59.5||At age 59.5|
|Taxes in Account||No taxes on dividends, capital gains, or interest||No taxes on dividends, capital gains, or interest|
To understand the differences between the two, it’s often most easily observed through a chart.
As you can see, Roth and Traditional 401K’s are very similar, with the exception of the pre/post tax difference. Unfortunately, only you can answer the question of whether or not you want to be taxed now or in retirement.
It’s a lifestyle choice based on your long-term vision for your finances.
Can’t figure it out? You could always split your contributions between the two!
Roth 401K Discussion:
- Does your employer offer a Roth 401K?
- Do you invest in a Roth 401K over a Traditional 401K or vice versa? Why?