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You've heard of a Roth IRA, but how about a Roth 401(k)? This under-used retirement vehicle is worth another look as part of your savings strategy.
A Roth 401(k) is an option within a workplace retirement plan to put aside after-tax dollars. Unlike better-known Roth IRAs, there's no income limit on who can participate — and the maximum annual contribution for workers under age 50 is more than three times higher. (See comparison chart from the IRS below.)
Adding a Roth 401(k) option has gotten trendy in recent years.
Seven in 10 employers now offer a Roth option within their 401(k), up from 54 percent in 2014, per a survey of large and midsize companies conducted by global advisory firm Willis Towers Watson. It's prevalent even among smaller plans, of which roughly 6 in 10 allowed after-tax Roth contributions during 2016, according to the Plan Sponsor Council of America's annual survey of profit-sharing and 401(k) plans.
But few employees are taking advantage of Roth 401(k) plans. Just 18.1 percent of workers across all plan sizes had made an after-tax Roth contribution to their workplace plan in 2016, PSCA data shows.
Nor are users putting much in. The average percentage of salary higher-paid employees defer to a Roth 401(k) is 4.8 percent, versus 7 percent for pre-tax 401(k) contributions, according to PSCA. (Among lower-paid employees, the average rates of Roth vs. pre-tax are 4.3 percent and 6.1 percent, respectively.)
Financial advisors say that low usage rate likely stems from a combination of factors, including lack of awareness and a mistaken belief that they make too much to contribute to a Roth 401(k). (To reiterate: That's not true.)
"I always ask clients if this is an option in their plan and the most frequent reply I get is, 'I'll have to check,'" said certified financial planner Howard Pressman, a partner at Egan Berger & Weiner in Vienna, Virginia.
Brian Schmehil, a CFP and the director of financial planning for The Mather Group in Chicago, says beefing up Roth contributions can also be a tough sell for the young workers who stand to benefit the most from those decades of tax-free growth.
"It's hard to pay tax now and have a much smaller paycheck, and have the foresight to know you're saving money in the long run," he said.
But even older and higher-paid workers would benefit by contributing at least a little to a Roth 401(k) option, if it's available, Pressman said. Having a portion of savings that can be withdrawn tax-free in retirement gives you tax flexibility.
"Otherwise, your tax bracket is at the whims of your lifestyle, and how much you withdraw," he said.
Here's how to make the most of a Roth 401(k) as part of your retirement plan:
Don't stop at asking if your company offers a Roth 401(k) option.
Review the match details. Some companies offer both pre-tax and Roth contributions, but only match pre-tax ones.
(It's also worth noting that the employer match is made in pre-tax dollars, so even if you only make Roth contributions you'll have both pre-tax and Roth balances.)
Work with your financial advisor to figure out the best way to incorporate a Roth 401(k) into your plan, along with other options available to you, said Amy Hubble, a CFP and the founding principal of Radix Financial in Oklahoma City, Oklahoma.
"You have to say, what's in the toolbox?" she said.
For example, advisors typically recommend contributing at least enough to your 401(k) to snag the full employer match, before you explore other retirement savings vehicles. That's valuable free money.
Then, she said, a worker could put "as much into a Roth 401(k) as you can possibly stomach."
But if you have a high-deductible health plan paired with a health savings account, maxing out that HSA is likely a more valuable play before turning to a Roth, she said. HSAs have a triple tax advantage: Contributions are either pretax or tax-deductible, typically grow tax-free and can be withdrawn without incurring taxes when used toward qualified medical expenses.
Should you switch jobs, weigh rolling Roth 401(k) funds into a Roth IRA rather than leaving them in a workplace plan, Schmehil said.
That can create an additional safety net for young workers who don't have a big emergency fund, he said. The key is in differences between the two kinds of Roth accounts.
Roth IRAs rules let users withdraw their contributions at any time without paying taxes or penalties. Roth 401(k)s generally don't, except in cases of hardship — and even then, the withdrawals are prorated between contributions and earnings, so a portion would be taxable.
A rollover can provide added flexibility in retirement, too, he said, since Roth IRAs aren't subject to so-called required minimum distributions. Those are required withdrawals one you turn age 70½. Roth 401(k)s don't have that same advantage — although like pre-tax 401(k) plans, there can be some exceptions if you're still working.
If you're close to retirement, keep in mind that so-called qualified Roth withdrawals (where the earnings are tax-free, too) kick in after the Roth account is at least five years old and the account holder is at least 59½, disabled or dead. That five-year waiting period starts on the first day of the tax year in which you make a Roth contribution.
If you open a new Roth IRA to roll over Roth 401(k) funds, that move re-starts the five-year clock. (Already have a Roth IRA? That holding period carries over.)
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