Many hard working Americans have access to a defined contribution retirement plan called a 401(k). Essentially, a 401(k) is a retirement savings vehicle provided by employers to their employees as a means for the employee to save for retirement, often with the employer providing a “match” of the employee’s contributions up to a certain percentage.
As of January of 2006 (a result of EGTRRA 2001), employers can now offer employees the Roth 401(k) as part of their 401(k) plan. Before we get into the advantages of the Roth 401(k), let’s briefly look at how the regular 401(k) works. Employees that have access to a 401(k) are generally allowed to contribute up to $17,000 (2012 figures, indexed annually) per year to their 401(k). Employees aged 50 and over are allowed an additional $5,500 (again, 2012 figures, indexed annually). Employee salary deferrals are taken from the employee’s earnings on a pre-tax basis – meaning the amounts going to the 401(k) are not taxed and thus allowed to grow tax deferred in the 401(k) until needed or required to be withdrawn at 70½ (RMDs). When withdrawn, they are then taxed at ordinary income tax rates.
Enter the Roth 401(k).
With a Roth 401(k), an employee’s salary deferrals are taken after the paycheck has been taxed – meaning after tax money goes into the Roth 401(k) account and is allowed to grow tax-deferred and qualified withdrawals are income tax free. Like its regular 401(k) counterpart, the Roth 401(k) requires RMDs to be taken at age 70½.
The Roth 401(k) offers an employee many advantages. The first is that an employee may make more money than would allow him or her to contribute to a Roth IRA. There are no such income restrictions or phase-outs in a Roth 401(k). Additionally, an employee can choose to save money to their Roth 401(k) if they feel they may be in a higher tax bracket at retirement or if they feel tax rates will increase in the future. Also, the maximum contribution to a Roth 401(k) is $17,000 annually versus $5,000 annually for a Roth IRA. Those age 50 or over are allowed to put in an additional $5,500 into their Roth 401(k), whereas those same people are only allowed an additional $1,000 for their Roth IRA. Finally, when an employee retires, they are allowed to roll their Roth 401(k) to a Roth IRA – without taxation or penalty, and avoid RMDs (remember Roth IRAs do not have RMDs).
The first place to check to see if you can take advantage of the Roth 401(k) is with your HR representative. Should you have access to this option, see if your employer will match your contributions to the Roth 401(k). The Roth 401(k) can make a lot of sense for those wanting to save even more money on a tax-advantaged basis.