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!

Why I chose a Roth IRA over a Traditional 401K

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As soon as I started reading my Suze Orman books, I got really excited about saving for retirement.  I remembered when I was in high school I would frequently tell myself two things:

1. When I turn 21 I'm going to work as a waitress, because in this town, waitresses make bank!
2. When I turn 22 I'm going to start my retirement account and by the time I retire, I'll be rich!

I actually only accomplished one of those goals... until now!  For the first time in my life (age 27) I have become eligible to participate in my employer's retirement options.    Until August of 2010, I had never had a full time job except school, so if I did work for a company who offered retirement benefits, I didn't qualify. 

Participating in a retirement plan has always been important to me because by the time I'm 70, there won't be much left in Social Security, if anything.  You're welcome Baby Boomer generation.  I hope you're enjoying being retired at age 55 as well as that nice boat my Social Security Contributions paid for...

Imagine my disappointment when I found out my company doesn't match retirement contributions!  Aww man!  It looked like I was on my own to secure my future; that's a scary thought for a twenty-something!  I had briefly studied the differences between 401Ks and Roth IRAs but take it from me, I am NO financial expert.  In the end I decided that the Roth was the way to go.  If my company had offered a match, I would have no doubt chosen a Traditional 401K,  anyone who turns down free money is a dummy!  But they don't, so I chose a Roth IRA.   

Why?  First and foremost I have a few very important cards up my sleeve when it come to retirement... the first being time!  I am young, I am just starting out in the business world, and I'm not going to retire for close to 40+ years.  The other card I have to play is that my career will inevitably change.  Currently I work in an office at a borderline entry level position.  I know I won't work here for the next 40 years, and I know that my salary will eventually increase (I'm currently a Pre-Med/Dental student).  What this means is that:

• I can contribute whatever amount I can, and it doesn't have to be a large amount.  Even $50 a month is better than nothing.  Because time is on my side, that $50 a month will grow and earn interest for the next 40+ years!
• With the Roth IRA, I am paying money with my "after tax pay."  Why is this better for me than a traditional 401K when the 401K is paid pre-tax?  Well currently, because I am entry-level, and in a very low tax bracket (about 15%), I'm not actually paying that much in taxes.  When I withdraw my funds at retirement time, the tax is already paid, so I what I have in my retirement account is what I can use. 
• With a 401K I am contributing with my "pre-tax pay" which seems awesome (hooray no taxes!  Take that Uncle Sam), and subsequently would put me into a lower tax bracket (Less income = lower income tax bracket).  Seems ideal right?  Consider this...  Currently, I am practically in the lowest tax bracket possible, and with my career plans (dentist), I am pretty much guaranteed to make more money in the future, putting me in a higher tax bracket.  When I pull out my retirement funds, I will be taxed based on the bracket I am in at that time.  Many dentists are in an income tax bracket of 40+%!   

Let's think about this and get a better visual of this explanation, I am 27 years old. I currently have $4,800 each year to contribute to my retirement.  My current tax bracket is 15% and my future tax bracket will be about 40+%.  If I retire when I am 70 years old, the money I can actually use from:

• A Roth IRA account would be $1.7 million
• A 401K account would be $1 million

Both of these numbers are crazy.amazing.great, but which would you rather have?  Again there are things to consider such as inflation, potential matching, other issues, etc. but this example is just for demonstration purposes.

The Roth IRA may not be the best retirement fund for everyone, but because I'm young, because I don't make a lot of money and therefore don't pay a lot of taxes, and because I (hopefully) have lots of time left to work, it's better for me to stick with the Roth.  For those who are a little further along in life, a Roth may not be the best way  to go.  It's important to get educated about your options and most importantly, start contributing, whatever you can, TODAY!  Even if it's just couch change, or one days worth of Starbucks, or your first born child, wait, not that..  Well you get the idea.