A Roth 401(k) is a retirement account that has some features of a regular 401(k) plan, and some features of a Roth Individual Retirement Account (Roth IRA). Each plan has its advantages and disadvantages. Which plan to choose depends on a person’s individual needs. The Roth 401(k) requires taxes to be paid up front. A regular 401(k) defers taxes until the money is distributed.
The Roth 401(k) acts like a Roth IRA when it comes to taxes on contributions to the account. That means that contributors must pay the taxes on their money before putting anything into the account. Once the money is in the account, no more taxes are due. However, this means that contributions are not tax-deductible. The tax benefit comes from the fact that regular withdrawals are not taxed. There may be substantial penalties for early withdrawals, but these are essentially the same as those for a regular 401(k).
A person who does not expect his tax rate to drop significantly after retirement would most likely do best with a Roth 401(k), so the taxes can be paid while he is still earning an income. Also, paying taxes when the money is invested removes the uncertainty, since tax rates may climb in the future. With the Roth account it doesn’t matter what her tax rate will be at retirement, since no tax will be due. Someone who is in a relatively high tax bracket might do better using a traditional 401(k), with the expectation that her taxes will be lower after retirement, but there are no guarantees.
There are limits to the amount of money that can be placed into a Roth 401(k). As of 2011, the maximum amount a person may contribute to all 401(k) plans combined is $16,500, and it is $22,000 if the account owner is 50 or older. For many people, this makes the Roth 401(k) more attractive than the Roth IRA, since the limits on the Roth IRA are $5,000 a year for workers under 50, and $6,000 a year for those who are older. Unlike the Roth IRA, the Roth 401(k) does not have an income ceiling, so anybody can contribute to this type of account.
A Roth 401(k) plan is a work-based program. In order to invest in this type of plan, it is necessary to work for a company that offers one to its employees. If the plan is not offered, it is possible to request that the employer make it available to employees. Many times, if enough people request the Roth 401(k) an employer will add it to the benefits package. Taxes and contributions are normally deducted prior to the distribution of pay.
- Hemera Technologies/AbleStock.com/Getty Images