For a little more than 10 years, the IRS has allowed employers to modify their 401(k) plan documents to allow Roth 401(k) contributions, which are after-tax contributions that enjoy the same tax-exempt status of a Roth IRA. However, there are some noteworthy differences between a Roth IRA and a Roth 401(k)—most significantly, the contribution limits.
With a Roth IRA, you can contribute up to $5,500 in 2016 with a $1,000 catch-up contribution if you are 50 and older. With a Roth 401(k), an employee can defer up to the amount allowed by the plan document, not to exceed the $18,000 annual limit for defined contribution plans. Catch-up contributions for those 50 and older can be up to $6,000. Furthermore, employees can make Roth 401(k) contributions regardless of their salary. The income limitations of Roth IRAs do not apply; therefore, high income earners do not have to use the backdoor method of converting an IRA to a Roth. In addition to the higher contribution limits, the other beneficial feature of Roth 401(k) contributions is the tax-exempt status. Contributions are made with after-tax dollars and then grow tax-free. Qualified distributions of contributions and earnings are tax-free.
The downside is that not all 401(k) plans are the same. Some plan documents do not offer the Roth contribution options while others may restrict Roth 401(k) contributions to a percentage of your total deferral—some as low as 15%. Employer matching contributions are always pre-tax contributions that will grow tax-deferred; therefore, a portion of your total 401(k) portfolio will always be taxable upon withdrawal. However, if your employer-sponsored retirement plan has the Roth 401(k) option, it is worthy of consideration.
While we always stress a diversified portfolio across many different stocks, sectors and asset classes, tax diversification is equally as important. Having a mix of tax-deferred and tax exempt funds in retirement allows you to control your tax situation while on a fixed income. Often investors spend their entire lives saving to a 401(k) and have only tax-deferred investments in retirement. At age 70 ½, traditional 401(k) account owners are required to take minimum distributions, which are taxed at ordinary income tax rates. If the required minimum distribution is significant, a meaningful amount could be lost to taxes. Other retirees may be in a situation where they have to withdraw more than they need for basic living expenses from their tax-deferred accounts just to pay the taxes, which could deplete a tax-deferred account faster. Having assets that are tax-exempt can provide more flexibility in retirement. While your Roth 401(k) distribution will be tax free, you still have to take minimum distributions at 70 ½. If you do not need the money and want to continue to let it grow tax free, you can roll the 401(k) into a Roth IRA.
Should you make Roth 401(k) contributions if the option is available? At the risk of sounding like a broken record: It depends. If you are in a high tax bracket now, traditional 401(k) contributions are made pre-tax, lowering your taxable income. If you expect to be in the same or higher tax bracket in retirement, Roth 401(K) contributions will provide tax-exempt funds in your later years. The main variable is your tax rate in the future. Tax laws change yearly, so even if today Roth 401(k) contributions make sense, circumstances could change in a few years.
Saving for retirement involves not only investment planning but tax planning too. If you have questions regarding how Roth 401(k) contributions may affect your overall retirement savings, the experts at Henssler Financial will be glad to help:
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- Email: experts@henssler.com
- Phone: 770-429-9166.