ROTH 401K - What is it Good For?

If you have read the previous two posts in this series, you already know why we dumped ING as our old 401K provider, and you know about the excellent features that will be included in our new plan. Today, I would like to write about one of these features in more detail: our ROTH 401K option.

Much like ROTH IRAs, a ROTH 401K allows employees to contribute after-tax dollars, however, the money is tax free when withdrawn in retirement. So what are the benefits of a ROTH 401K and who is it good for?

Let's start with tax diversification. Believe it or not, we are living at a time in which taxes are at historically low levels. When you consider that the federal government is running a deep budget deficit, social security is projecting a massive shortfall and medicare costs are projected to skyrocket in the coming decades you have to ask yourself, who will pay for all these expenses? Well, dear citizen, look no further than the nearest mirror. Many believe that tax rates must increase in the long run to cover these costs and, if you believe that thesis, you may want to pay your taxes now and save yourself from a bigger tax bill in the future.

If you are just beginning your career and expect your retirement tax bracket to be higher than your tax bracket today, a ROTH 401K might be right for you. Your ROTH 401K contributions will be taxed at your current low rate, rather than at the higher tax rate you expect in retirement. This is typically true of young workers in low tax brackets who only get a meager tax break when contributing to a regular 401K.

A nice feature of ROTH 401K is that your eligibility to contribute is not limited by your household income. If your company offers a ROTH 401K, you are eligible. ROTH IRAs on the other hand have eligibility thresholds. For example, married couples can only contribute to a ROTH IRA if their household income is below $166,000 per year. Highly paid individuals that want to invest in a ROTH, can do so through the ROTH 401K.

Finally, if you contribute to a ROTH IRA consider this: while the IRA only allows you to contribute $4,000 per year, the ROTH 401K gives you many of the same advantages but allows you to contribute $15,500 this year. That's pretty impressive.

I haven't decided whether to contribute to a ROTH 401K or go for the traditional version, primarily because there is a good chance that my tax rate in retirement will be lower than it is currently. I will keep you posted when I make a decision.

Tomorrow's post will discuss some interesting aspects of 401K matching.