What’s a Roth 401(k)?
If you know anything about retirement plans, you probably know about the big guys: the 401(k), the traditional IRA, and the Roth IRA. But what about the Roth 401(k)?
Quick review of the more well-known plans: A 401(k) is a tax-deferred retirement plan offered by your employer, meaning money is deducted from your paycheck before taxes, but you pay taxes when you withdraw the money in retirement. An IRA is a retirement account you set up yourself: A traditional IRA offers an up-front tax break by letting you deduct your contribution from your income for that year, while with a Roth IRA you pay taxes before you contribute, but then you’ll never be taxed again.
The Roth 401(k)—a combo of the Roth IRA and 401(k)—is the new kid in town. It began in 2006, and only a third of employers offer it, as of the last count. But it could grow in popularity now thanks to a provision in the Small Business Jobs Act (SBJA) that makes it easier for some 401(k) holders to switch to a Roth 401(k).
Why would you want to switch? In a sense, the Roth 401(k) is the best of both worlds: the tax advantages of a Roth IRA and the company support (and, often, matching program) of a 401(k). The amount you can contribute is the same as a 401(k): up to $16,500/year for most participants, with an extra $5,500 for workers 50 and older. However, while money in a regular 401(k) is deducted pre-tax, Roth 401(k) funds are deducted from your after-tax income.
Here’s the catch (you knew there’d be one!): If you switch from a pre-tax 401(k) to an after-tax Roth 401(k), you have to pay taxes on the funds you’re converting. (Just like when you switch from a traditional IRA to a Roth IRA.) This tax payout may turn off older workers who have a considerable amount built up in their account and can more easily afford to pay taxes in smaller increments, as they withdraw funds post-retirement, than in one huge lump. Generally, paying taxes now through the Roth option is good for workers who expect to end up in a higher tax bracket by retirement, or who are concerned that tax rates will rise in the future.
Would you switch to a Roth 401(k)?
