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Why I Contribute to a Roth 401k

The number one reason I contribute to a Roth 401(k ) rather than a traditional 401(k) is that I am protecting myself from a confiscatory (taxes) government.  Our Government is on pace to go belly up thanks in large part to entitlement programs out of control costs.  I believe there is a good chance that in the future taxes will be raised substantially to pay for all these programs.   Contributing to a Roth 401(k) is a form of tax diversification in that at retirement I can pull from a traditional IRA and pay tax then or take from taxable investments and pay tax at a capital gain rate or draw from my Roth IRA and owe $0 in federal tax.

You 401k balance is not really yours!

What?    


 

Your statement balance is not what you really own.  You need to subtract the ordinary income taxes from the balance to get the real surrender/cash value of you 401k plan or IRA.

401k or IRA balance Ordinary Tax Rate Tax Owed After Tax  401k or IRA Balance
$500,000 28% ($140,000) $360,000
$500,000 40% ($200,000) $300,000

 

While most people will not cash out their 401(k) all at once, the fact remains that when you take money out it is added to your other ordinary income and taxed at your marginal ordinary income tax rate.  Take out too much in one year and it may cause your social security income to be taxed.  This is another hidden penalty of relying on your 401(k) for retirement income.

  • Unlike a Roth IRA, there are not any income restrictions on a Roth 401k that keep many people from contributing to a Roth IRA.
  • The obstacle may be that your employer does not offer this opportunity.  Most 401k plan providers will offer this if your employer requests it to be an option for their employees.
  • You employer can still make matching contributions.  Those would go into a separate pre-tax basket within your plan and be taxable at distribution.
  • The contribution limits are the same as a traditional 401(k), now $18,000 per year and $24,000 for people over age 50. You can contribute this if you have “earned” income to contribute.
  • Unlike a traditional 401(k), the contributions are NOT tax deductible when they are made.
  • The account grows tax free.
  • WHEN THE MONEY IS WITHDRAWN AFTER AGE 59 1/2 IT IS NOT TAXED BY THE FEDERAL GOVERNMENT.
  • Also, while with traditional 401k and IRA’s you are required to take an annual distribution after reaching age 70 ½, with a Roth there is no required minimum distribution
  • Unlike a traditional 401k or IRA the money will pass to your beneficiaries TAX-FREE.

WHAT IF YOU NEED MONEY PRIOR TO AGE 59 1/2:

The only way you can access your funds without a 10% early withdrawal penalty if under age 59 ½ is if you need the money to do any of the following:

  • Pay medical expenses.
  • Cover the down payment or avoid eviction or foreclosure on your principal residence.
  • Pay college tuition.
  • Cover funeral expenses for a family member.

Bottom Line:

If you expect your tax rate to be the same or higher in retirement than it is now, you might be better off with a Roth 401k.   If you believe the your tax rate will go down in retirement, you may be best off with the traditional 401k, but if you think the federal income taxes may go up when it is your time to take distributions and would like to have different pots of money to pull from, than you’ll benefit from starting a Roth 401k.

Please call me if you would like to set one up for your small business or have other tax related questions, 630-942-9007.

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