Roth 401k Plans – What Are They and Should You Invest In Them?

Recently, while reading David Bach’s book, Fight For Your Money, I read a passage describing a new type of investment instrument that is being offerred by some employers for their employee’s retirement savings.

It is called a Roth 401k. First, let’s take a look at exactly what a Roth 401k is.

What is a Roth 401k?
In a previous post (see link below), I sorted through the decision making process of whether a Roth IRA or Traditional IRA is better suited for your needs.

My Money Blog – Roth IRA vs. Traditional IRA

A Roth 401k has many of the same characteristics as a Roth IRA. The attributes of Roth 401k’s are listed below:

• Offered through your employer’s benefits department.
• Employees contribute funds to the Roth 401k on a post-tax elective deferral basis, in addition to, or instead of, pre-tax elective deferrals under their traditional 401k plan.
• Combined pre-tax and post-tax contributions to a 401k is still limited to the regular $16,500 maximum contribution required by the government.
• Key Feature
• Withdrawals/earnings from the Roth 401k account will be tax free, provided that the Roth 401k account has been open/active for > 5 years and you are 59.5 years of age or older.

For more information on Roth 401k accounts, click on the link below:
Wikipedia.org – Roth 401k

Is a Roth 401k Right For Me?
A general rule of thumb that can be used is that if you determined (from decision process in previous post at link above) that a Roth IRA is best for you, then a Roth 401k is a good investment decision for you as well.

As we discussed in the previous post, the decision to elect a Roth 401k over a Traditional 401k hinges on what tax bracket you currently are in and what bracket you will be in upon retirement (when you want to choose to pay the taxes on your investments).

• If you think you will be in a higher tax bracket when you retire, a Roth IRA/401k is best for you.
• In general, this situation applies to most young (18-30 year old) investors who start saving money early and expect to have accumulated a good nest egg when they retire.
• If you think you will be in a lower tax when you retire, a Traditional IRA/401k is best for you.

The article shown at the link below from Wikipedia.org provides a good matrix comparison of the benefits of both types of 401k programs.

401k – Roth vs. Traditional Matrix

Another tool that I found in doing some research on this topic is shown below. It is a calculator that allows you to enter several details about your financial situation, and then it projects 1) the effect on your current income and 2) the effect on your income during retirement, as a result of electing to use either a Roth or Traditional 401k plan.
Schwab.com – Roth 401k vs. Traditional 401k Calculator

At age 24, my results were as follows:

• Using a Roth 401k will decrease my current take-home pay by 7%, over a Traditional 401k.
• Using a Roth 401k will increase my annual income during retirement by 41%, assuming that my tax bracket stays the same as it is now.
• If my tax bracket increases from 29% (now) to 35% at retirement, using a Roth 401k will increase my annual income during retirement by 54%. Wow!

How Accessible Are Roth 401k’s?
So, in my case, it would clearly be beneficial for me to use a Roth 401k account. However, the program is that these types of accounts are not readily being adopted by employers. I just called the benefits center at my work, and they said that they do not offer a Roth 401k option.

In fact, it is estimated that only 1 in 4 employers currently is offering a Roth 401k as an account option.

So, don’t be too dissappointed if this option, while good, is not yet available to you.

Key Takeaway
Roth 401k’s, like Roth IRA, are a relatively new form of investment tool/account that is slowly being adopted in to our society.

Everyone should analyze their own situation carefully to determine if a Roth plan is right for you. If it is determined that paying tax now with a Roth account is better than waiting until retirement, it is beneficial to 1) open up a Roth IRA and 2) call your current employer to ask if they offer a Roth 401k as well.

Keep on learning!

Jacob

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