Recently, a number of readers have asked me about the new Roth 401(k). Is it really a good deal, they ask? In a nutshell, it’s a very good deal for almost anyone eligible for it, but let’s walk through the scenario carefully.
What Is A Roth 401(k)?
A Roth 401(k) is not all that different than a regular 401(k). In most regards, it works exactly the same – your employer manages the plan, the money is taken directly out of your paycheck and put into the investment, and once in the investment, you can control the investments to whatever degree you wish (or your employer allows).
The first difference (and this is the one that’s a bit of a negative) is that your contributions to a Roth 401(k) come after taxes. Let’s say that you’re currently contributing 10% of your salary to a normal 401(k) and are thinking of switching to the new Roth 401(k). When you make that switch, you will lose that 10% as a tax deduction, which will increase your tax bill right now.
The second difference (and this one makes up for that downer and more) is that when you make withdrawals from this 401(k), you pay no taxes at all on any withdrawal. Of course, you have to wait until you’re eligible to withdraw money normally from a 401(k), which requires that you have started the plan five years ago or more or are 59 1/2 years old.
If your employer does matching, this will remain in pre-tax dollars and will go into a normal 401(k).
How Does That Work Out?
Let’s use another common straw man example. Let’s say that our hero Joe is in the 28% tax bracket and he puts $10,000 a year into his 401(k) right now – that means that Joe doesn’t have to pay taxes on that $10,000. If he moved to putting that money into a Roth 401(k), he would be able to put in the same $10,000 a year, but he would have to pay taxes on that before it went in, bringing his total bill for that $10,000 contribution up to $12,800. If Joe does this for thirty years, he’ll have paid $84,000 in extra taxes to have the money in a Roth 401(k) versus a regular 401(k).
But trust me, Joe’s going to be happy in retirement. Let’s say Joe retires and he has enough in his 401(k) that he can take out $50,000 a year for the next thirty years, until he’s 90 and passes away. He’s again in the 28% tax bracket. So, when he withdraws the $50,000 from the Roth 401(k), it’s all his! He has $50,000 to spend! But if he were to withdraw the $50,000 from the regular 401(k), he would have to pay $14,000 every year in taxes and only be able to keep $36,000 of the money – over the 30 years, he’ll pay a total of $420,000 (!) in taxes. Let’s even say his tax bracket was lower than that in retirement – let’s put him in the 15% bracket at retirement. He would still have to pay $7,500 each year in taxes and only keep $42,500. He’d still pay $225,000 in taxes over those years.
Basically, by paying $2,800 a year now in extra taxes, Joe saves himself $14,000 a year in retirement.
You can make complex models with inflation and other elements to the point of confusion, but the Roth 401(k) still comes out ahead in almost every scenario – and far ahead in most scenarios. If you still have questions and doubts, the retirement counselor in your workplace, who can work you through your specific scenario in detail.
What About A Roth IRA?
If you have access to a Roth 401(k) and your only purpose is to contribute money for retirement, a 401(k) will suit your needs. The one advantage that a Roth IRA has over a Roth 401(k) is the ability to withdraw your contributions without a tax penalty, but the additional benefits of the Roth 401(k) (especially employer matching if your employer offers that) are so great that you should contribute the maximum to the Roth 401(k) first if it’s available to you.