By Kristi DeRycke, Registered Assistant
Roth 401K is a word that we are hearing more often lately. Many more companies are offering the Roth 401K option in addition to the Traditional 401K than they did 5 or 10 years ago. Saving for your retirement is already confusing and now there is another option. I wanted to try to break it down for you.
Let’s take the original 401K plan first as you are more familiar with it. You decide what percentage of your paycheck you will contribute to the 401K. Your company may offer a match. (Quick soap box: make sure you are contributing enough to get your full match. This is FREE MONEY!) So the money that you contribute is pre-tax. That means if you make $50,000 annually and you set your contribution at 10% that means $5000 of your money will be set aside in the 401K. The company will then add money to your $5000 depending on their offered match. The best part…..you will only pay taxes on $45,000 income and not the original $50,000. The money in your 401K will then grow and you won’t have any other taxes on it until you take it out. You can start withdrawing at 59 ½. There is also a Rule of 55. This allows you to take money out of a 401K from the company you are working for if you are fired, laid off or quit that specific job. Any 401K from a previous company that you left prior to 55 is not included in this option. You are then taxed on any withdrawal from your Traditional 401K as ordinary income. The assumption is that you will be in a lower tax bracket at this time in your life. You have to take required minimum distributions (RMDs) at 70 ½.
Okay now to tackle the Roth 401K. Any money that you contribute to the Roth 401K is put in after taxes. So it will not reduce your income for taxes as stated above. It does grows without tax incident and you can start to withdraw at the same time as a traditional 401K typically 59 ½ with same options as stated above for age 55. The magic of the Roth 401K is that you are NOT taxed on the money when you take it out. You had paid the taxes when you first put it in before it grew to the amount it is at retirement. This means that you were taxed on the money put into the account but not any growth that occurred on the money through the investments. The Roth may be an attractive option for those currently in a low tax bracket that expect to move into higher brackets later. This is beneficial if tax rates increase over time. It can be advantageous for big savers who grow bigger nest eggs. It could be a good option for someone that may want to roll their 401K over into a Roth IRA at retirement or when leaving a job. There are no required minimum distributions required on Roth IRAs even if the money was originally in a Roth 401K. If you were to roll a Traditional 401K to a Roth, you would have to pay taxes on the money at the time of the rollover. The taxes were already paid on the money that went into the Roth 401K so that would rollover to a Roth IRA without further taxes. Technically if the money remains with your company in the Roth 401K, you have to take required minimum distributions by 70 ½ but you could avoid this by rolling it into a Roth IRA. There is one thing you should understand if contributing to a Roth 401K. The percentage of money that you declare as your contribution will go into the Roth. The match dollars that your company puts in are required by law to go to the traditional pre-tax 401K option.
The maximum allowed for 2019 for either option is $19,000 ($25,000 if over 50 years of age). Still not sure which to put it in? We can help? Did you know that as a member of Royal Alliance, Greg Johnson, can be the financial advisor on many local 401K plans including Unity Point, University of Iowa, Pepsi, John Deere, AEGON, University of Norther Iowa, Pella windows and many more local companies? If we are not listed as an advisor option, we still have options to assist with your 401K plan.
www.morningstar.com Traditional 401(k) or Roth 401(k): Which Is Right for You?
www.finra.org Smart 401K Investing
By Greg Johnson
The Roth 401k has been a great addition to the options employees have to save for their retirement nest egg. The key for most people is they need to know if they have it available to them or not. Most people I have met with over the last few years haven’t even known if they have it or don’t have it available to them. Ask questions and find out because I believe tax rates will not be going down again in the near future. Who knows for sure, but with our country’s debt at the levels it is, infrastructure being in trouble, and social security and Medicaid being a complete nightmare I have to believe tax rates will be higher in the next 20 years than they are today. Why does that matter you ask? Well if you are saving money into the pre-tax traditional 401k plan all you are doing is deferring the date on which you pay your taxes. If tax rates go significantly higher you may find yourself paying more in income tax in your retirement years than you do today. Investing in the Roth 401k gives you the ability to have tax-free income in your retirement with no worries about tax rates at that time.
Check out your options and talk with you tax preparer and financial advisor to see if it makes sense for you to invest in the Roth 401k option today.