Are you missing out on the chance to contribute to what I often refer to as a “scarce resource”—a Roth-type or after-tax retirement account? Before you assume you’re not eligible to contribute to this account because of your generous income level, consider this: You may be able to invest in a Roth through your 401(k).
Many employers—maybe including your own—now offer Roth 401(k) plans. According to the research firm Aon Hewitt, more than half of all companies now offer a Roth as part of their retirement plans. The Roth 401(k) has been around since 2006. If you’re self-employed, you may be able to set up your own solo 401(k) plan with a Roth component.
The Roth 401(k) can be ideal for higher earners. Unlike a regular Roth IRA, your income doesn’t bar you from contributing to these plans. I see three big advantages to a Roth 401(k): Maximum flexibility, magnification of your contributions, and the fact that tax-free retirement savings opportunities are so few and far between for higher-income individuals.
Flexibility is Key
If you’re in a lower or similar tax bracket now compared to where you think you’ll be in retirement, the Roth 401(k) may be for you. You won’t get a tax deduction for your contributions right now, as you would with a traditional retirement plan. However, the big bonus is that you’ll withdraw both your contributions and any earnings from your Roth tax-free after you retire. Believe me: That “zero tax” phenomenon will make you very, very happy.
Also, a Roth 401(k) can help you avoid the required minimum distributions (RMDs) that you must take from traditional retirement plans beginning at age 70 ½. How? You simply covert your Roth 401(k) to a regular Roth IRA before you hit that magical age. You’ve already paid taxes on this money, so there’s no new tax bill when you convert. You can then withdraw from your Roth whenever you like—with no forced RMDs—or leave the account to grow.
The Roth is a supercharged asset to leave to a beneficiary, by the way. If you leave a Roth to a child or grandchild, withdrawals are tax-free for them, too. It’s hard to think of a better package in which to wrap an inheritance.
You can contribute the same amount to a Roth 401(k) as you would to a regular 401(k): $17,500 per year, or $23,000 if you’re age 50 or older. (Those figures are your maximums for all workplace 401(k)s combined). However, $17,500 contributed to a Roth 401(k) really has a different economic value: You own 100% of it.
On the other hand, $17,500 invested in a regular IRA is actually worth less, because you’ll pay taxes when you withdraw it. That’s why I tell folks that your contributions to a Roth 410(k) are “magnified.” It’s almost as if you’ve contributed an extra 25% or 40%—or whatever your tax rate—to your retirement plan.
Tapping a Scarce Resource
As you know, it’s incredibly tough for higher-income folks to find investment options with tax free withdrawal options. You’re probably not eligible for a regular Roth IRA, for one thing. And even if you were, you could only contribute $5,500 per year (or $6,500 if you’re age 50 or older). Your traditional retirement plan contributions, employer matching funds, profit-sharing options, and bonuses are all taxable. So you can think of the Roth 401(k) as a drink of cold, cold financial relief in a tax-heavy desert landscape.
I strongly encourage you to take another look at this unique version of the Roth. If your employer offers a Roth 401(k) or you are eligible to set up a solo 401(k) with a Roth section, give it some careful consideration. As always, your Wealth Advisor can help you decide whether this investment tool is right for you.
Aon Hewitt Source:
Roth Usage in Defined Contribution Plans: http://www.aon.com/human-capital-consulting/default.jsp
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