If your company offers a 401k, you’re in luck because 401k’s are one of the best tools at your disposal to retire comfortably. What many people don’t realize however is that you may have options in your 401k that you didn’t know existed. For example, many people don’t know that Roth 401k’s exist and that they may be an option in their own 401k. But this knowledge can be very powerful and may be the difference between thousands of dollars worth in taxes.
Intro to Roth 401ks
A Roth 401k is kind of like a super Roth IRA. It is similar to a traditional 401k in that it allows for you to save for retirement in a tax advantaged way and allows your company to make matching contributions. It differs from a traditional 401k in that your contributions are “after-tax” contributions. This means that you’ve already paid the income tax on your income before making the contributions. This differs from your contributions into a traditional 401k as you do not pay income taxes on those contributions, but instead pay income taxes upon withdrawal from your account. Employer contributions in traditional and Roth 401ks are the same, they remain “pre-tax”, i.e. you don’t pay income taxes until you withdraw from your account.
The difference between Roth 401ks and traditional 401ks are almost identical to the difference between Roth IRAs and traditional IRAs.
The younger you are and the lower your tax bracket, the better a Roth 401k will serve you. This is because when you are younger, you have more time to allow the contributions you’ve made grow tax free before you withdraw them tax free. If you’re in a lower tax bracket, then the taxes you pay on your contributions have less of an impact on your ending balance, than they would if you were in a higher tax bracket.
The most important and basic difference between your contributions into a Roth 401k and a traditional 401k is that when you withdraw from your account at retirement, you will not pay taxes on your contributions to a Roth 401k; in a traditional 401k, you will pay income taxes on all of your withdrawals.
Why Bother with a Roth 401k?
The two main reasons that I advocate for “Roth” style accounts to my clients are 1) flexibility and 2) tax diversification.
More Flexibility with a Roth 401k
A Roth 401k can be directly rolled into a Roth IRA. Once you’ve rolled your Roth 401k to a Roth IRA you can treat it just like a Roth IRA. Two super nice advantages of a Roth IRA as compared to a traditional IRAs or 401ks are that you can always access your contributions tax and penalty free for any reason you’d like and you are not subject to required minimum distributions at age 72.
Access to Contributions in a Roth 401k
Imagine that you came across a sweet investment opportunity, say a piece of real estate or the next bitcoin. If you had a Roth 401k, you could access your contributions tax free by rolling your account into a Roth IRA (you can’t access your Roth 401k funds completely tax free while they are still in the 401k account). Once your funds are in your Roth IRA, you could pull your contributions for any reason at all and make your investment without worrying about taxes or penalties!
Depending on how old your Roth IRA was, you may or may not get tax and penalty free access to the earnings (not contributions) in your account, but that’s ok. If you’ve been making regular contributions, it’s likely that your contributions make up a large portion of your account.
A traditional 401k on the other hand would have you first pay income taxes and then slap on a 10% penalty if you were below age 59 ½. There are ways to avoid this penalty but none of them are super attractive.
Another hypothetical may be a backup emergency fund incase of a medical emergency or natural disaster. With a Roth 401k and/or Roth IRA, if unforeseen circumstances wipe out your emergency fund, you won’t be relegated to paying a ton of taxes or loading up your credit cards.
Tax Diversification with a Roth 401k
My second favorite reason to advocate for “Roth” style accounts is tax diversification. Nobody knows what the future tax code is going to be. Various changes to the tax code over the years have made certain investments and accounts more or less attractive at different times. For example, the Economic Recovery Tax Act of 1981 made commercial and residential real estate investing more attractive while the Tax Reform Act of 1986 had the exact opposite effect on commercial and residential real estate.
Because we can’t know how future tax law will impact our investments or investment accounts, we need to hedge our bets with different kinds of accounts. The three types of tax exposure available to all investors are 1) taxable accounts 2) after-tax accounts 3) pre-tax accounts. Roth IRAs and 401ks fall in after-tax exposure. Traditional IRAs and 401ks cover your pre-tax investments and after you’ve managed to cover your pre-tax and after-tax exposures, you can open a simple taxable brokerage account, savings account, or make other kinds of investments. As you’ll see in the next section, this will allow you to avoid some unpleasant surprises in the current tax code.
Avoiding Required Minimum Distributions with a Roth 401k
Since the IRS gave you a nice tax break by not taxing your contributions, they want to make sure you distribute your account over your lifetime so that they can tax those contributions and earnings. The problem is that you are required to make distributions according to a schedule dictated by your age and account value. You have to make these distributions even if you have no need for the money at all!
This means that if you were planning on using these funds to leave as a legacy or inheritance for your children or grandchildren, they will get less because you will be forced to liquidate a certain amount of your account each year after age 72 and pay taxes on that amount. And you will be paying income taxes, not friendlier capital gains taxes.
Required minimum distributions apply to Roth 401ks as well but Roth IRAs have no such required minimum distributions. The IRS has already taxed the money and you are free to spend it or horde it as your please. Your heirs will inherit the funds tax free (although they will be required to distribute the account over a period of time). Therefore, by simply rolling your Roth 401k into a Roth IRA you can avoid this hassle.
With such stipulations for pre-tax accounts, you might wonder why anyone bothers with a pre-tax account to begin with. A few reasons are 1) not everyone has access to a Roth 401k, 2) your age and income can make a Roth 401k less beneficial than a traditional 401k and 3) we still don’t know the future so tax diversification is still a smart thing to do.
Takeaways about Roth 401ks
If you are younger and have access to a 401k through your employer, you would be doing yourself a disservice if you did not inquire with your HR about Roth contributions. The flexibility, future tax free withdrawals, and tax diversification are all advantages you can gain by having one. If you do not have access to a Roth feature in your 401k, you can still open a Roth IRA and contribute up to $6,000 annually (2021).
Be sure to check out this article about Risk and Asset Allocation in your 401k!
Erik Goodge is a CERTIFIED FINANCIAL PLANNER™ and the President of uVest Advisory Group. He holds a B.S. in Economics and Cognitive Science from the University of Evansville. Erik is a Marine Corps veteran of the Afghanistan campaign and Purple Heart recipient. He is from Evansville, Indiana, and currently lives in near-by Newburgh with his wife and daughter.