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Millionaire Money Habits

February 27th, 2008 at 12:45 pm

Response to Reader: What is a Roth 401k?

A reader posted the following comment on Maximum Allowable 401k Contribution:

“Curious what your thoughts are on Roth 401k’s? Thanks!”

Good question, Marjory. Let me see if I can answer your question as clearly as possible. First, let’s define what a Roth 401k, or Roth-K for short, really is.

If you are familiar with a Roth IRA, it is essentially the same concept but with all the benefits of a traditional 401k. As the name implies, it’s a combination of a Roth IRA and a traditional 401k.

IRAs: A Roth IRA is an after tax contribution to a retirement plan. The benefit is that the money you withdrawal during retirement is tax-free.

A traditional IRA is a tax deductible contribution, which means it basically works out to be a pre-tax contribution. The difference is a traditional IRA is taxed when you withdrawal funds during retirement, whereas a Roth IRA you pay income tax and then invest what is left over.

With an IRA there are limits as to how much you can contribute ($5,000 max IRA contribution for 2008).

401k: A traditional 401k is a pre-tax investment contribution through your employer, which means you invest before you are taxed on your paycheck, but you pay taxes on the investment when you withdraw funds during retirement.

The advantage of a 401k over an IRA is the maximum contribution is much higher ($15,500 max 401k contribution for 2008), and your employer may match a percentage of your contribution. The disadvantage, which is usually a minor inconvenience if any, is that you have a limited number of investment funds to choose from based on what your company offers.

Roth-K: A Roth 401k is the best of both worlds. With a Roth-K, you contribute after-tax dollars through your employer’s retirement plan and the maximum contribution limit is $15,500 for 2008. You pay taxes on your paycheck first, and then you contribute to your retirement plan. In this scenario you are not taxed on the money you withdraw during retirement.

Note that an individual can contribute to both a 401k and an IRA, which means you can actually invest $20,500 a year in a tax-sheltered retirement fund, plus employer contributions. It is not possible to contribute to both a 401k and a Roth 401k though.

So What’s the Advantage?

At first glance, the difference between a Roth 401k and a traditional 401k probably doesn’t seem that different. You’re either paying taxes up front or on the back end. What’s the big deal?

Let’s look at an example. Say you make $2,000 for two weeks of work and invest 10% of your income into your 401k. With the traditional plan you invest first ($200), and then you are taxed on the $1,800 that is left over. With a Roth-K you are taxed first and then invest 10% of what is left.

For convenience, let’s say you are in the 25% tax bracket:

$2,000 Paycheck Traditional 401k Roth-K
Investment Amt. $200 Not Yet
Taxed on Income 25% of $1,800 = $450 25% of $2,000 = $500
Take Home Pay $1,350 $1,500
Invest in Roth   $150
Roth Take Home   $1,350

In the example above you invested less in the Roth 401-k, but that investment will grow and compound into a much larger amount and will not be taxed when it is worth more.

With the traditional 401k option, you invested more money upfront and reduced your realized income by $200 for the two week period, which means you pay less income tax, but you will have to pay taxes when you withdraw those funds during retirement.

How Do I Chose?

First, you may not have a choice. The Roth 401k is still a fairly new product and not being offered by many employers.

If you wan to minimize your realized income in order to remain in a lower tax bracket, the traditional plan can help you do that. But if you think capital gains taxes will increase 20 years from now when you retire and will have a big affect on your retirement, think about the Roth. After a lifetime of investing $400,000 that has now turned into $1.5 million, would you rather be taxed on the $400,000 when you contributed to the retirement fund or the $1.5 million when you withdraw?

If you have a choice, the recommendation would differ depending on your situation. Here are a couple things to think about:

Once money is in a conventional 401(k) account, it can’t be moved over to a Roth version.

  • If you are just starting your career and expect to be in a much higher tax bracket during retirement, you may consider taking advantage of the Roth-K now.
  • As a young investor, time is one of the greatest assets because compound interest will make the investment grow several times over. Take advantage of tax-free compounding money by contributing to a Roth 401k.
  • If you believe the government will increase taxes over time, a Roth-K allows you to pay today to avoid heftier tax bills later.
  • Currently the Roth IRA are forbidden by couples who earn over $160,000 a year, and singles earning over $110,000 a year. A Roth 401k does not have these income limitations, so if you are a high income earner this gives you an opportunity to have a Roth option.

If your employer offers you an option between a 401k and a Roth 401k, see for yourself what your better option may be by using the Forbes Roth 401(k) Analyzer.

Millionaire Money Habit: It can be pretty complicated when deciding between your investment options, but the minor difference in retirement plans can have a major impact on how much money you have at retirement. Do your due diligence before making an investment decision and seek the advice of a trusted financial adviser. -RT
photo by urban_data

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  • Marjory
    9:53 am on February 28th, 2008 1

    Great to see your article on this. Many, many thanks for the analysis. Very helpful!


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