7 Reasons for Begging Your Employer to Offer a Roth 401(k)
1. Tax-Free Withdrawals in Retirement
With a regular 401(k) plan, all the good news on income taxes happens on the front end. You get to deduct the amount of your contribution from your taxable income for each year that you put money into the account. That lowers your income tax liability each year that you make a contribution.
That arrangement works especially well if you're currently in a high tax bracket. The theory on tax deferral is that you take the tax break now -- when you're in a high tax bracket -- then withdraw the money in retirement, when presumably you'll be a lower bracket. Save big now, pay small later -- fair enough.
But where a regular 401(k) is concerned, you're merely deferring your tax liability, not eliminating it. Since your contributions to the plan were tax-deductible when made, and since all investment earnings accumulated in the account since inception have been tax-deferred, any and all withdrawals taken during retirement will be subject to income tax.
%VIRTUAL-pullquote-A Roth 401(k) is a remedy to this dilemma.%A Roth 401(k) is a remedy to this dilemma. Unlike a regular 401(k) plan, your contributions to the plan are not tax-deductible when made. But just like a regular 401(k) plan, any investment earnings that accumulate within the plan are tax-deferred. Based on these two facts alone, it appears that a traditional 401(k) plan is superior to a Roth 401(k).
But here's where a Roth 401(k) makes a radical departure from a regular 401(k): Money withdrawn from a Roth 401(k) plan is completely tax-free, not merely tax-deferred. The only requirements for this status is that you have to be at least 59½ when you begin taking distributions, and you have to have been a participant of the plan for a minimum of five years.
While the news on income taxes favors regular 401(k) plans prior to retirement, the advantage shifts entirely to a Roth 401(k) plan when you are retired. And that's the time that it will really count.
2. Income Tax Diversification
Tax deferral is probably the main reason why so many people take tax-sheltered retirement plans. It's a way to shield current income from high taxes and defer taxes on investment earnings within the plan.
But an often-overlooked strategy in retirement planning is income tax diversification. It's important to realize that the general assumption that you will be in a lower tax bracket when you retire may not be what happens. This is particularly true if you do have a variety of income streams. Consider the potential income sources you could have in retirement:
- Your Social Security benefit.
- Your spouse's Social Security benefit.
- The annual distribution from your regular 401(k) plan, especially if it has a very healthy balance.
- Any pension income that either you or your spouse have.
- Rental real estate income.
- Non-tax sheltered investment income.
- Any income from employment, self-employment or passive income arrangements.
If that's the case, your cash flow will be helped immensely if at least some of your income is derived from non-taxable sources. Because withdrawals from Roth 401(k) plans are tax-free, these plans qualify as a form of income tax diversification for retirement.
This is even more important since Social Security is subject to income tax, based on your overall income. If your investment income is high, a greater percentage of your Social Security be subject to income tax. If a substantial amount of your income is tax-free, such as distributions from a Roth 401(k) plan, then less of your Social Security benefits will be taxable.
You won't be able to do much to change that arrangement by the time you retire. That's why it's important to do something now.
3. If You're In a Low Tax Bracket Right Now
If you are in a low tax bracket right now, say the 10 percent or 15 percent marginal rate on the federal, you should have even greater interest in participating in a Roth 401(k) plan.
When you're in a lower tax bracket, the benefit of income tax deferral from regular 401(k) plan contributions is minimal. For example, if you are in the 15 percent bracket, you'll save $1,500 this year by contributing $10,000 to your regular 401(k) plan.
Now everyone can use extra $1,500. But let's say that your retirement income turns out to be higher than your income during your working years, and you're in the 28 percent tax bracket. You will pay $2,800 on a $10,000 withdrawal from your regular 401(k) plan. That means that while you saved $1,500 when you made the contribution, you'll paid an additional $1,300 when you withdraw the money in retirement. ($2,800 - $1,500). Using a Roth 401(k), you'll pay the $1,500 in tax now, but save $2,800 in retirement.
The calculation is actually more complicated, because between the time you made the contribution and the time you withdrew money, you also invested the money and generated tax-deferred income. But the point still stands -- you'll be paying 28 percent on withdrawals of money that saved you only 15 percent at the time you made the contributions.
That's a negative exchange, even factoring investment income tax deferral. However if you have a significant amount of money in a Roth 401(k) plan by the time you retire, the distributions that you take have a plan could very well keep you out of that higher tax bracket in the first place. Not to mention that at least some of your income will be completely tax-free.
4. You'll Probably Still Get the Employer Match
Even people who do have a Roth 401(k) plan at work often fail to take advantage of it out of fear that they won't get the company matching contributions the way they would with a regular 401(k) plan. While it's true that not all employers provide the company match for a Roth 401(k) plan, some do. You need to investigate this.
Employers that do extend the company match to the Roth 401(k) plan typically place the match into the regular 401(k) plan. If they do that, it's OK. It will enable you to have all the benefits of a Roth 401(k), while also helping to expand contributions of your regular 401(k).
5. No Required Minimum Distributions
One of the lesser-known benefits to a Roth 401(k) plan is that it does not impose the required minimum distribution rule. On virtually every other tax sheltered retirement plan, you are required by the IRS to begin taking mandatory plan withdrawals -- subject to income tax -- no later than age 70½. The withdrawals are at least loosely based on your remaining life expectancy, and there are stiff penalties if you fail to take them.
We can think of this as the government's way of forcing money out of tax-sheltered plans, where it can finally be taxed as ordinary income. If you are trying to minimize your income tax liability by deferring withdrawals from tax-sheltered plans, that strategy will only work until you turn 70½.
The Roth 401(k) plan is exempt from RMDs. You can allow the money in the account to grow for the rest of your life, enabling you to pass the full amount of the account on to your heirs. That's an excellent estate planning strategy, and it also provides you with 100 percent control over all of the money and income that you have in the account.
6. More Flexibility for Your Life in Retirement
Having a well-funded Roth 401(k) plan gives you options for retirement.
Let's say that rather than waiting until 65 or 67 -- or what ever the Social Security Administration determines your age of normal retirement to be -- you decide that you want to semi-retire at 60, while you are waiting for Social Security benefits to begin. A Roth 401(k) plan can help you.
You can choose to live on a mix of part-time employment or business income, along with regular distributions from your Roth 401(k) plan. The tax-free nature of the withdrawals from the plan will be especially important since the portion of your income that is earned from a job or business will be subject to FICA taxes.
You can take distributions from a Roth 401(k) plan in lieu of Social Security income. You can also rely on Roth 401(k) distributions, so that you won't have to touch your regular 401(k) plan before you fully retire.
With people living longer than ever, worrying about out-living your money has become a common retirement concern. But a Roth 401(k) plan is one of the best solutions to that problem.
Since there are no RMDs, you can leave the money in a Roth 401(k) plan for as long as you want, and it will continue to grow. In the meantime, you can live primarily on your regular 401(k) plan, and when that begins to deplete, you can begin taking withdrawals from your Roth 401(k) plan -- at any age you decide upon.
You can think of it as a two-tiered retirement strategy, with one plan to cover you in the early stage of retirement, and the other -- the Roth -- continuing to grow so that it will take care of you in the later stages of your retirement.
7. Advance Protection From Widely Anticipated Income Tax Increases
A lot of experts predict that income tax rates will only get higher in the future, probably much higher. When you consider the size of the national debt -- now officially at nearly $18 trillion -- and the retirement of tens of millions of baby boomers -- higher taxes in the future are practically a given.
The current top federal income tax rate is 39.6 percent -- but additional taxes on high income earners push the effective rate into the mid-40s. But that rate is reasonable by historic standards. The top federal income tax rate hit 94 percent during World War II, and it remained no lower than 70 percent until 1981. A budget crisis or a swamping of the Social Security and Medicare systems could push tax rates much higher than we can imagine right now.
%VIRTUAL-pullquote-They may tax everything else you have -- but not your Roth 401(k) plan.%Once rates are increased substantially, it will be too late to do anything in reaction -- short of simply refusing to earn or accept additional income. The best strategy to deal with the anticipation of higher tax rates is preparation. A Roth 401(k) plan -- with its tax-free withdrawals -- represents exactly that. They may tax everything else you have -- but not your Roth 401(k) plan.
The combination of three benefits give you more flexibility with a Roth 401(k) plan than virtually any other plan you can have -- taxable or tax-sheltered:
- Tax-deferred investment earnings.
- Tax-fee withdrawals.
- No required minimum distributions.
That's why you need to beg your employer to offer a Roth 401(k). And if your begging doesn't work, you still may have the option of opening a Roth IRA. Here's a look at some of the best places to open your own Roth.