The Roth 401(k) is a relatively new option for retirement investing and an interesting mix of two different types of accounts: the regular tax-deferred 401(k) and the Roth IRA. Is it the right option for your retirement investing?
As with any investing choice there are pros and cons to each account and investment. Let’s look at some of the major advantages and disadvantages of the Roth 401(k).
Advantages of Using a Roth 401(k) for Investing
Here are some positives to using a Roth 401(k) to save for retirement:
1. Pay Taxes Now Like a Roth IRA
Roth 401(k)s have the same tax treatment as a Roth IRA. With these Roth investment accounts you choose to pay taxes now at your current income tax rates rather than deferring them to retirement. Whether or not you see this as an advantage or disadvantage depends on your anticipation of future tax rates in general as well as your own personal future tax rates. Many people believe that tax rates will be higher in the future, which makes a Roth 401(k) a smart way to save for retirement.
2. Higher Contribution Limit than a Roth IRA
If you do like Roth accounts over the Traditional 401(k) and Traditional IRA where you can defer taxes until retirement, then you should love the Roth 401(k). The account is treated just like a Roth IRA but it has a contribution limit about three times higher than a Roth IRA.
3. Low Effort Investing
Setting up a Traditional IRA or Roth IRA means you have to research a brokerage firm, different investment options, fill out paperwork to open the account, and either set up automatic contributions or remember to invest regularly. That is a lot of effort for busy individuals.
Investing in your workplace 401(k) is significantly easier. Contributions come out regularly from your paycheck. You do have to make investment selections when you set up the account, but the pool of potential investments are significantly smaller than at a brokerage firm which makes selection an easier process.
Disadvantages of Using a Roth 401(k) for Investing
Here are some drawbacks to using a Roth 401(k) for your retirement investing.
1. Fewer Investing Choices than IRAs
When you invest through your employer’s 401(k) option you inevitably have fewer investing choices than you have by investing on your own with an IRA. When you look to open up an IRA with a brokerage firm you can choose the best firm for your specific situation; the firm that offers the right investments for your investing goals.
With the Traditional 401(k) and Roth 401(k) you are stuck with the investment options your company chooses to put into the plan. You could end up with great, low cost index investments if your company chooses wisely. Alternatively you can be stuck with high cost investments. With IRAs you simply have more choice.
2. Can’t Pay Taxes Later
If you prefer to invest in tax-deferred accounts because you believe you tax rate will be lower in retirement, then the Roth 401(k) is not the right investment vehicle for you. You are better off with a Traditional 401(k) or IRA option.
3. No Penalty-Free Early Withdrawals
One of the biggest benefits of a Roth IRA is that you can withdraw your contributions at any time. Since you already paid income tax on the money before it was invested, you can pull the fund out whenever you want. (You cannot withdraw earnings until retirement, just contributions.)
Even though a Roth 401(k) is funded with the same kind of income (post-tax) as a Roth IRA it is still tied to the withdrawal rules of a regular 401(k). That means any early withdrawals before retirement are hit with a 10% early withdrawal penalty.
An even bigger kicker? If you take a non-qualified distribution from your Roth 401(k) you can end up paying taxes on the withdrawal even though you funded the account with post-tax income. The amount of the withdrawal that is taxable will be in relation to the value of your account versus the contributions that got you there. For example, if you have $100,000 in your Roth 401(k) and only contributed $75,000 over the years that means $25,000 is from earnings. If you had a non-qualified distribution of $10,000 from the account then 25% of that withdrawal would be taxable income. (And you still get hit with the 10% early withdrawal fee.)
4. Required Minimum Distributions
In addition to the withdrawal rules of a regular 401(k), Roth 401(k)s are also tied to “Required Minimum Distributions.” Individuals must begin to make minimum distributions according to IRS regulations by age 70 ½ from both regular and Roth 401(k)s. This requirement is not in place for Roth IRAs where the entire account will be willed to an heir if the investor so chooses.
Is a Roth 401(k) Right for Me?
Deciding whether or not to use a Traditional 401(k) or a Roth 401(k) comes down to several factors in your financial life. If you want more flexibility out of your investments and don’t want to be required to withdraw funds, then you should look to a Roth IRA instead.
On the other hand, having contributions directly taken from your paycheck like your regular 401(k) is a nice perk. If you prefer to pay taxes now, then a Roth 401(k) can be a great investment account especially with the high contribution limit compared to a Roth IRA.
What are your thoughts on the Roth 401(k)? Leave a comment and let us know!