Why I Contribute to a Roth 401k , Don’t Pay Taxes Later!

The Roth 401k is my favorite personal investment wrapper.

What is a Roth 401k? – An employer sponsored retirement plan that allows you to automatically contribute a portion of your income from your paycheck.

Who can contribute to it? – Any employee that has access to such a plan with no income limitations just like a traditional 401k. If your employer offers a traditional 401k, but not a Roth 401k, ask the person in charge to add this option. It should not be an additional expense for the employer.

How does it work? It’s a paycheck deduction plan just like a traditional 401k.  Unlike a traditional 401k, the contributions are NOT tax-deductible. A traditional 401k, the growth of the money is not taxed (tax-deferred). The big difference is that withdrawals after age 59 ½ are income tax-free!

Why I contribute to a Roth 401k

The number one reason I contribute to a Roth 401(k) rather than a traditional 401k is that I am protecting myself from a confiscatory (taxes) government.  Our U. S. Government is currently $20,000,000,000 in debt – (click amazing debt clock) and that number is growing by the thousands, literally every second of the day! This is due to the government spending more that it brings in via taxes. In large part to the use of entitlement programs (social security, Medicare, etc.) and other out of control costs.  I believe there is a good chance income taxes will be raised substantially in the future to pay for all these programs.

 

 

Contributing to a Roth 401k is a form of tax diversification in retirement.  At retirement, I’ll have the option of pulling money from a traditional IRA and pay tax then at my ordinary income tax rate. Take from taxable investments and pay tax at a capital gain rate, or draw from my Roth IRA and owe $0 in federal tax. I look forward to being able to having this tax flexibility.

You 401k balance is not really yours!

What?    

Roth 401K

 

Your 401k 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 of a 401k or IRA 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.

Key Points:
  • 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 to having a Roth 401k 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 in 2017 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 deferred.
  • WHEN THE MONEY IS WITHDRAWN AFTER AGE 59 1/2 IT IS NOT TAXED BY THE FEDERAL GOVERNMENT.
  • Also, while with traditional 401k’s and IRA’s you are required to take an annual distribution after reaching age 70 ½. With Roth 401K 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.

Click to Visit the IRS site for specific details

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 your tax rate will go down in retirement, you may be best off with the traditional 401k.  You may also like the idea of  diversifying and create the Roth 401 to give you more flexibility during retirement.

 

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