Gather Little by Little

I received a letter from my employer the other day stating that they will begin offering a Roth 401k program in addition to our traditional 401k program beginning in 2009. I had read a little bit about them in the past, but decided since they were now an option for me to begin utilizing, I should probably learn more about them and wanted to share my findings with you as I understand they are becoming more and more prominent.

What is a Roth 401k?

The Roth 401k program allows you to contribute post-tax dollars to an individual retirement account but allows for tax-free growth and distribution. This differs from a traditional 401k program in that a traditional 401k contributes pre-tax dollars for contribution and then upon distribution is taxed at normal levels.

How does a Roth 401k differ from a traditional 401k?

A Roth 401k is very similar to the traditional 401k program, but with three primary differences:

1. Contributions to your Roth 401k are done after taxes, not before like a traditional 401k. The negative here is that the Roth 401k doesn’t reduce your taxable income.
2. Distributions from a Roth 401k are tax free. Distribution requires that you’ve been contributing for at least 5 years or are 59 1/2 years old or more.

The Roth 401k advantage

The  big advantage of the Roth 401k is to those that expect to be in a higher tax bracket when they retire than they are now. The Roth 401k deducts taxes at contribution time hence if you will be in a higher tax bracket when you retire, you’ll be paying far less taxes than you would with a traditional 401k program.

For example, let’s say you contribute $20,000 to a Roth 401k. If you 20,000 grows to $60,000 over the years than at retirement (or distribution time) you pay no taxes on the $40,000 gain. This differs from a traditional 401k plan in that you would pay taxes on the entire $60,000 at distribution time.

Is the Roth 401k the best option? This is a tough and complex question to answer due to inflation, marginal vs. effective tax rates, etc. The models can become very complex, but based on my research in almost every scenario the Roth 401k provides you with more retirement money than a traditional 401k. Deciding on which option to choose should not be made lightly though. I would strongly advise consulting with your employers HR area where they can provide further data based on your income, tax rates, and age.

Final considerations

There are few additional items to consider:

• Your employer may or may not match contributions to the Roth 401k.
• You can contribute to both a traditional 401k and a Roth 401k as long as your total contributions do not exceed IRS regulations.
• You can convert form a traditional 401k to a Roth 401k, however you will be taxed.

Does your employer offer a Roth 401k? What are your thoughts? Are there any considerations I’ve missed? Add a comment!

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