Firt things first... what is a ROTH 401k?
Technically, its not a type of 401k, rather it’s a designated ROTH account within many 401k plans offered by employers. Not every employer’s 401k plan has a ROTH designated account. However, this is an easy addition for the employer -- often it’s a simple change to the plan documents and a matter of turning on the feature on the investment website. The ROTH side treats your contribution differently. You realize the income on your taxes today, but all your contributions and earnings, if withdrawn after age 59 ½, are tax-free.
If you have access to contribute to both the pre-tax traditional side of your 401k and the ROTH side, which should you use? The default funding option is generally the traditional pre-tax side, which allows for a tax deduction today, but requires you to realize the taxes when you withdraw the funds later in retirement. Its important to remember that your company match and any profit-sharing the company may put into the plan will also be taxable to you later. Therefore, since the taxable side is already being funded, it might make sense to build some optionality into future income buckets.
For example, if I build all my wealth in totally taxable accounts then I have nearly no control over my tax bracket in retirement. Every dollar I pull out to support my retirement will be taxable. Whereas if I had a few sources that were tax favorable and perhaps provided for tax free withdrawals, then I might be able to control how much taxable income I have in any given year, allowing me the opportunity to manage my income tax bracket better.
In favor of having more options for pulling income from taxable and non-taxable sources, it seems funding the ROTH account is a prudent approach to building wealth. Remember, the ROTH is just a tax registration, not an investment vehicle. The underlying funds within your account, whether it’s the ROTH or the pre-tax side are what drive your expected growth.
When would you not fund your ROTH account, and what else should you know? There are few circumstances that would merit not funding a tax-favorable account like your ROTH designated account. The first is to carefully consider your total MAGI (modified adjusted gross income) if you are 2 years away from becoming Medicare eligible, meaning you are age 62. If your MAGI is likely to be over $91,000 as an individual or over $182,000 married-filing-jointly, then you may want to contribute more to the pre-tax side as this will lower your MAGI and keep you under these Medicare surcharge thresholds. Medicare looks at the second year prior MAGI to determine if a surcharge is to be applied. This only really applies if you are close to these thresholds, as the difference in premium may simply offset the taxes you would have hoped to save.
Another situation you may not want to fund the ROTH account is if you are nearing retirement and do not have an individual ROTH IRA already established outside of your company plan. If you do not have a ROTH IRA that has been seasoned, that is, it has been open and funded at least five years prior, you will not be able to take out your gain from your ROTH portion of your 401k without incurring a penalty. Therefore, I advise everyone to open a ROTH IRA, even it its just a token account at a bank using something like a CD and a low dollar investment. This starts the clock on that pesky five-year rule. Once this five-year rule has been satisfied, then you can roll any ROTH money from a 401k plan into this seasoned account at retirement without incurring a penalty on withdrawing earnings (assuming you are over the age of 59 ½ of course).
So, there you have it, a few ideas and considerations when it comes to funding the ROTH account within your company sponsored retirement plan.
Bradley Ruh Owner, Financial Adviser