For millennials, there are many benefits to positioning the Roth provision on your company’s 401k plan. If you compare them to a standard Roth IRA, you will realize the loopholes that offer some exceptional savings opportunities.
A Roth IRA can only participate in a $5,500 annual contribution for years 2015 through 2017, unless you are above age 50 and take advantage of the additional $1,000 catch-up provision. A Roth 401k can allow up to $18,000 of qualified contributions years 2015 through 2017. If you are tax filing as a single individual for the upcoming year 2017, you are phased-out for Roth IRA contributions once your adjusted gross income goes above $133,000. However, a Roth 401k has no income limitations. In a Roth 401k, you are typically able to participate in an employer match (assuming your 401k plan provider offers a matching program). The company match is always on a pre-tax basis, but you could still make your after-tax Roth contributions to the account and still be eligible to receive the matching compensation. When thinking about your personal income levels between now and when you plan to retire, do you anticipate making more money each year, less, or the exact same dollar amount each year? Most would assume your income would increase with your tenure in the workforce. There have been a lot of speculation about state and federal income tax rates—whether they will increase, decrease, or stay the same between now and retirement. Having the option to contribute to a Roth 401k levels out your taxable versus tax-free income streams when you are retired, which effectively allows you to control how much you want to pay in taxes each year during retirement. This is an option only available people who incorporate Roth contributions to their retirement savings plans!
Consider the concept of compounding interest between a taxable vehicle (pre-tax contributions) and a tax-free vehicle (Roth contributions). Now say you invest $500 today inside a pre-tax account, like your traditional 401k plan, and you do the same $500 contribution to a post-tax account, like the Roth 401k. Assuming these two accounts get funded the exact amount, grow for the same amount of years, and achieve identical rates of return the Roth 401k will provide a greater return in retirement.
The reason is this: when you spend your pre-tax 401k money in retirement, each dollar comes out with an income tax (usually between a 20 to 40% rate). In that case, you would only be able to spend 60 to 80% of your pre-tax 401k money, whereas the Roth 401k comes out tax-free, and you will actually spend every dollar of the account value, because none of it goes to Uncle Sam in the form of taxes.
If you haven’t explored the Roth 401k provision yet, you should consider sitting down with a financial advisor to learn if this strategy fits in your overall planning.
Article by Andrew Kirwin
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The information in this material is not intended as tax or legal advice. It may not be used for the purpose of avoiding any federal tax penalties. A distribution from a Roth 401k is tax-free and penalty-free, provided the five-year aging requirement has been satisfied and one of the following conditions is met: age 59½, disability, or death. All investing is subject to risk, including the possible loss of the money you invest. Withdrawals taken prior to age 59½ or five years may be subject to ordinary income tax or a 10% federal penalty tax, or both. HTK does not provide legal and tax advice. Always consult a qualified tax advisor regarding your personal tax situation and a qualified legal professional for your personal estate planning situation.