Roth 401K, The New Kid on the Block.

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Did you know I recently went to a New Kids on the Block (and Backstreet Boys) concert?  It was LEGIT!  I seriously had the best time! 

Speaking of New Kids on the Block, have you heard of a Roth 401k?  Wait, Morgan, I thought it was either a Roth IRA or a 401k?  In the past a traditional 401k or a Roth IRA were the two main retirement options, but since 2006, there's a new kid in town; the Roth 401(k), and sorry Donnie Wahlberg, he's looking finer than you...

A few weeks ago I spent a good couple of days researching 401(k)'s and Roth IRA's, and had decided to go with a Roth IRA when I became eligible for one at work.  I even went so far as to research different mutual funds and stock options!  Imagine my disappointment when open enrollment at my company came, and a Roth IRA was not an option! D'oh! Crap, now what?!  My only investment options were a traditional 401(k) or a Roth 401(k)?

A Roth 401(k)?  What?

Generally a Roth 401(k) is a hybrid between a Roth IRA and traditional 401(k).  It seems to have most of the benefits of a Roth IRA, with most of the benefits of a traditional 401(k); the best of both worlds!  In my opinion, it's a darn good way to go when it comes to saving for retirement.  And ultimately, it's why I chose it as my employee retirement option (although, I am in the process of setting up a separate Roth IRA account).

It's like a Roth IRA because:

Just like a Roth IRA, with a Roth 401(k), after-tax money is invested; you miss out on the initial tax break [that you get from a traditional 401(k)], but you're taxed your current income tax and not taxed a penny when you take out your money after age 59 ½ (typically when you're in a higher tax bracket).  Not even your interest earnings are taxed!

A Roth 401(k) may also be rolled over to a Roth IRA account, tax free.  This is great for people who know they will likely change jobs in the future.  [A traditional 401(k) can also be rolled over to a traditional IRA with no tax payment, but if it rolled to a Roth IRA, you will pay taxes on that amount.]


It's like a 401(k) because:

A big difference between a Roth IRA and a Roth 401(k) are the penalties paid for early withdrawals.  Some people choose to use their Roth IRA as an emergency savings account.  What this means is that you deposit your after-tax money, which grows because of interest.  You are allowed to withdraw money from the principle (the money you personally invested) at any time you choose, but you are not allowed to withdraw money earned through interest [just like a traditional 401(k)].

Let’s say you contributed over a 3 year period just $8,000 to your Roth 401(k). Lets also say that over those three years your ROTH 401(k) grew to $10,000. So $2,000 (or 20%) of your account balance is the earnings portion of your Roth 401(k), and $8,000 is from your contributions. The 20% is the important figure here. Now let’s say you need to take $8000 out of your ROTH 401k. Here is how it will work. When you withdraw $8000, 20% of the $8000 or $1600 would be taxed as ordinary income and if you were not at least 59.5 years of age at the time of withdrawal you would also owe a 10% penalty on that $1600 as well.

With a Roth IRA you could have withdrawn $8,000 of contributions penalty-free regardless of your age. With a Roth 401(k) there is no way to designate that you only want to withdraw from contributions

Another difference comes into play with employer matching.  If you receive an employer match, it will work like the match for a traditional 401(k), the money given to you by your employer will be taxed when you pull it out at retirement.

The Roth IRA option isn't available to people who make more than a certain income ($105-120K for singles, and $167-177K for couples).  With a Roth 401(k) you don't loose eligibility if your income grows too large. 

Roth IRAs also have limits to how much money you can put into them.  Typically (in 2009), the contribution limit was $5,000 each year.  So if you had one Roth IRA, you could save a maximum of $5,000 each year; but if you had 5 Roth IRA accounts, you could not contribute $5,000 to each account, only $1,000.  Like the traditional 401(k), the Roth 401(k) has a $16,500 yearly contribution limit, allowing you to save the maximum amount for retirement.

Points to Ponder

Because the Roth 401(k) plan is still so new, it is pretty rare; most companies don't offer them (only about 10% of companies in the US).  If yours doesn't bug the heck out of your HR department to offer one! I can't tell you what type of account to choose, but as far as us young people, who have a lot of working years left in us, I think this is the best way to go.  Just to review:

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The Bottom Line

Saving for retirement is so important, and us YF&Bers (twenty to thirty somethings) can not rely on Social Security to be there for us.  Start saving today, whatever you can.  Research the best option for you, and then follow Rule #1 of retirement planning: Don't touch your retirement savings until you retire!