Roth 401k

Roth 401k

Well I planned on starting this blog with more introductory articles on the basics investing tools available, but my employer just decided to offer a Roth 401k plan and I have to fill out the form today so I figured I’d blog about my decision process when filling out the form.

For those of you who don’t know a Roth 401k is a new savings vehicle that the IRS is releasing as of January 1, 2006. A Roth 401k is very similar to a Roth IRA in that any money you contribute to the plan you have to pay taxes on. The good news is that because you paid the taxes on the money up front any money you make a long the way is tax free and when you withdraw any money from this account after age 59.5 the money is also tax free.

As with any plan there are advantages and disadvantages. The biggest drawback to a Roth 401k vs a Traditional 401k is that you don’t get a tax deduction on any contributions you make. So you end up paying more to uncle sam up front. So in order to maintain the same amount of actual dollar contributions to your 401k account you have to take a bigger chunk out of your paycheck.

For example lets say every week I get a paycheck for $1000 and I contribute 10% of my salary to my Traditional 401k plan (not Roth 401k). Contributions that I make to a traditional 401k are tax free (but withdrawals are not).

Traditional 401k Roth 401k
Gross Income $1,000.00 $1,000.00
Pre-Tax Contribution -$100.00 $0.00
Taxable Income $900.00 $1,000.00
Soc Sec Tax (7.65%) $76.50 $76.50
Federal W/H (15%) $135.00 $150.00
State Tax (6%) $54.00 $60.00
After Tax Contribution $0.00 -$100.00
Take Home Pay $634.50 $613.50

So in order to contribute the same amount of money to my 401K it is going to cost me an extra $31 out of every paycheck.

Now In my example I make roughly $57,000 a year and currently contribute 14% pretax to my Traditional 401K (just under $8k a year). Which works out to about $307 every paycheck (bi-weekly pay).

Now if I wanted to keep the same dollar amount and contribute to a Roth 401k I would need to contribute about 19.6% or $431 per paycheck. So it will cost me $124 extra out of every paycheck (or $3224 per year) just to contribute the same amount to my 401k. Ouch!!

Now lets say I wanted to keep my paycheck the same and contribute to the Roth 401k. Now if I keep my contribution at 14% and switch to a Roth 401k, my paycheck deduction will remain at the $307, but unfortunately before that money gets to my account I need to pay taxes on it. So $307 x( 1 – .15 + .06 + .0765) = $219.04 or only $5695 per year. That’s a loss of nearly $2300 per year in my retirement savings.

Now time for the advantages. #1 I don’t have to pay any taxes when I withdraw my money at retirement. With a traditional 401k any withdrawals are taxed as normal income. So lets say I do pretty well for myself or the government gets crazy with taxes and I am in a 35% tax bracket when I retire, well the government gets 1/3 of any money I withdraw from my Traditional 401k account. Seeing as how I am in the 15% tax bracket now it makes sense for me to pay the taxes up front as if everything goes as planned I will be in a lot higher tax bracket when I retire.

If I leave the company I can roll my Roth 401k into a Roth IRA. Now this may not seem like that big of deal, but currently all retirement plans except for a Roth IRA have minimum distribution requirements. What does this mean? Well the government says once I get to age 70.5 I need to take some money out of my retirement accounts whether I need it or not. So lets say I have more money than I know what to do with and I don’t need to touch my 401k or IRA accounts, I’d rather let the money keep growing tax free for my children or grandchildren the government won’t let me do it. By rolling the money over into a Roth IRA though I can leave my money growing tax free as long as I would like.

The longer you have until retirement the better your odds of the tax free withdrawal advantage has to overcome the tax free contribution. As you see from above it costs a lot more to contribute to a Roth vs a Traditional. If you only have a few years till retirement you probably won’t be able to overcome the amount of money you had to pay in taxes up front. But if you are a somewhat young person like myself (26) with 33 years till retirement the Roth option will definitely leave me with more money at retirement. At the bottom of this article there is a Roth Analysis tool that is pretty good. You can play with it to so which option suits you best in retirement. You can select a level paycheck or a level contribution (examples I listed above).

Another advantage to the Roth 401k which doesn’t necessarily affect me is that if you make lots of money $95,000 filing single or $150,000 filing jointly you cannot contribute to a Roth IRA, but these people can contribute to a Roth 401k. This gives these people a chance to sock some money away that can be withdrawn tax free.

I guess my explanations took up to much room and I will continue my actual thought process with a different post.

Roth 401k resources

401k HelpCenter

Roth 401k Analysis Tool