savings

The Benefits of the Roth 401(k)

If you earn too much to contribute to a Roth IRA, your employer may offer a solution.

My wife and I are both 54 years old, and we each earn a six-figure salary. We are currently maximizing our contributions to our employers’ traditional 401(k) plans. Does it make sense for us to contribute to a Roth 401(k)?

Yes. You are in an ideal situation to benefit from investing some or all of your future 401(k) contributions in a Roth 401(k) -- if the option is offered by your employer -- particularly because your income is too high to contribute to a Roth IRA. (You’re eligible to contribute to a Roth IRA only if joint income is less than $191,000 in 2014.)

Roth contributions don’t reduce your tax bill now, but you can withdraw all of the money in the account tax-free after you reach age 59½ and have had the account for at least five years. Traditional 401(k) contributions, on the other hand, lower your taxable income now but are taxable when withdrawn. If most of your contributions so far have been to a traditional 401(k), contributing some money to a Roth 401(k) can be a great way to diversify your tax situation in retirement.

“It gives most people more flexibility in retirement,” says Stuart Ritter, a certified financial planner with T. Rowe Price. If you need to take a lump sum withdrawal -- whether for travel, a retirement house or medical expenses -- you can tap the Roth without any tax consequences. But if you take a lump sum from a traditional 401(k) or traditional IRA, says Ritter, “you’ll have to take more than you actually need since you’ll pay part of the withdrawal in taxes.”

Withdrawals from traditional retirement accounts also boost your adjusted gross income, which has a ripple effect. “The entire amount from the traditional 401(k) is included in your AGI, which can then push you into a higher tax bracket, increase your Medicare premium and subject more of your Social Security benefits to taxes,” says Ritter. Withdrawals from Roth 401(k)s and Roth IRAs, on the other hand, aren’t included in your AGI.

If you expect your tax rate to drop ten percentage points or more in retirement and you’re over age 50, then contributing to the traditional 401(k) could provide more spendable income in retirement, says Ritter. “But even if the traditional 401(k) gives you a bit more spendable income, the diversification and flexibility offered by the Roth might still make that the more compelling choice.”

For more information, see Invest in a Roth 401(k) If You Can.

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