By Brad Rosley

Editor's note: In the U.S., those saving save for retirement can use any number of accounts, products and investments. One such account is the Roth 401(k), which allows participants to make after-tax contributions to their 401(k) plan. Contributions accrue earnings tax-free and allow for tax-free distributions in retirement. In this report, Brad Rosley provides details about the Roth 401(k) that those saving for retirement should know.

Who can contribute to it? Any employee who has access to such a plan. Much like a traditional 401(k), there is no income limitation to participate. If your employer offers a traditional 401(k), but not a Roth 401k, ask the person in charge to add this option. It should not be an additional expense for the employer.

How does it work? It's a paycheck deduction plan just like a traditional 401(k). Unlike a traditional 401(k), the contributions are not tax-deductible. In a traditional 401(k), the growth of the money is not taxed (tax-deferred). The big difference is that withdrawals after age 59½ are income tax-free.

Why I contribute to a Roth 401k: The No. 1 reason I contribute to a Roth 401(k) rather than a traditional 401k is that I am protecting myself from a confiscatory (taxes) government. Our U.S. government is currently over $20 trillion in debt and that number is growing every day. This is due to the government spending more that it brings in via taxes. I believe there is a good chance income taxes will be raised substantially in the future to pay for all these programs.

Contributing to a Roth 401k is a form of tax diversification in retirement.

At retirement, I'll have the option of pulling money from a traditional IRA and pay tax then at my ordinary income tax rate. I can take from taxable investments and pay tax at a capital gains rate or draw from my Roth IRA and owe $0 in federal tax. I look forward to being able to have this tax flexibility.

Your 401(k) balance is not really yours. Your 401(k) statement balance is not what you really own. You need to subtract the ordinary income taxes from the balance to get the real surrender/cash value of your 401(k) plan or IRA.

401(k) or IRA balance

Ordinary Tax Rate

Tax Owed

After-Tax 401(k) or IRA balance

$500,000

28%

($140,000)

$360,000

$500,000

40%

($200,000)

$300,000

While most people will not cash out their 401(k) all at once, when they take money out of a 401(k) or IRA, it is added to other ordinary income and taxed at the marginal ordinary income tax rate. Take out too much in one year and it may cause Social Security income to be taxed. This is another hidden penalty of relying on your 401(k) for retirement income.

Things to Remember

Unlike a Roth IRA, there are not any income restrictions on a Roth 401(k). That keep many people from contributing to a Roth IRA.

The obstacle to having a Roth 401(k) may be that your employer does not offer this opportunity. Most 401(k) plan providers will offer this if your employer requests it as an option for employees.

Your employer can still make matching contributions. Those would go into a separate pre-tax basket within your plan and be taxable at distribution.

The contribution limits are the same as a traditional 401(k), now $18,500 per year in 2018 and $24,500 for people over age 50. You can contribute this if you have "earned" income of at least your contribution amount.

Unlike a traditional 401(k), the contributions are not tax deductible when they are made.

The account grows tax-deferred.

When the money is withdrawn after age 59½ it is not taxed by the federal government.

Also, while with traditional 401(k)s and IRAs you are required to take an annual distribution after reaching age 70½, with Roth 401(k) there is no required minimum distribution

Unlike a traditional 401(k) or IRA the money will pass to your beneficiaries tax-free.

What if you need money prior to age 59½? You can access funds without a 10% early withdrawal penalty if under age 59½ is if you need the money to do any of the following:

  • Pay medical expenses
  • Cover the down payment or avoid eviction or foreclosure on your principal residence
  • Pay college tuition
  • Cover funeral expenses for a family member

Read more from the IRA about designated Roth accounts.

If you expect your tax rate to be the same or higher in retirement than it is now, you might be better off with a Roth 401(k). If you believe your tax rate will go down in retirement, you may be best off with the traditional 401(k). You may also like the idea of diversifying and create the Roth 401(k) to give you more income flexibility during retirement. Watch Why I contribute to Roth 401k

About the author: Brad Rosley, CFP, is the founder and president of Fortune Financial Group and a member of the Financial Planning Association of Illinois.

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