The Power of the Roth 401(k)

Employers are increasingly offering a Roth 401(k) alongside a Traditional 401(k), which is a good thing for employees.

It affords you the advantage of paying an income tax today on your contributions in exchange for having total, absolute tax free growth on all future earnings (e.g. dividends and capital gains).

This is in contrast to Traditional 401(k)s. With Traditional 401(k)s,  you contribute pre-tax dollars today, which is great! But…you have to pay, at time of withdrawal, income taxes on not just your contributions but also your earnings.

So, Traditional 401(k) = No income taxes today. Deferred until retirement.  But, at time of retirement, look out: Taxes on total amount: Contributions you made and all those gains you had through all the decades leading up to retirement.

Or, Roth 401(k) =  Income taxes today. Not deferred.  But no income taxes paid again, ever. Not on contributions. Not on earnings. Home free!

Yet some high wage earners may be less than enthused at this prospect.

They may be asking themselves: Is the current income tax rate truly more favorable than the one I will find myself in in retirement?

This question is especially relevant for high wage earners who find themselves in the 33% and above income tax brackets.

While a good problem to have (a higher tax bracket is a result of higher income), am I at risk of being in a lower tax bracket at the time of retirement?

I might be.

However, if I make that assumption and not contribute to a Roth 401(k),  I will lose the snowball effect of having decades of earnings accrue tax free.

I would also lose the distribution flexibility a Roth IRA provides, since I am not required to make an RMD (Required Minimum Distributions) with a Roth IRA. (NOTE: assuming here that you are rolling over your Roth 401(k) to a Roth IRA in later years. This is the only way to avoid RMDs: Rolling the Roth 401k  over to a Roth IRA. This is not the same strategy of rolling over a Traditional IRA to a Roth IRA, since the tax treatment between a Roth 401k and a Roth IRA are the same.).

So while it’s hard to predict if I, or you, will be in a lower tax bracket or not, what is certain are these 2 key benefits to a Roth 401k:

1. The earnings you accrue on your contributions to your Roth 401(k) are yours totally tax free.

2. You don’t have to take a distribution on the account if you don’t want to (assuming you’re rolling over to Roth IRA from Roth 401k).