If your company sponsors a 401(k) plan, or if you are considering doing so, you likely know that contributions to the 401(k) are generally made on a pre-tax basis, which is a great way to reduce taxable income. However, you may not know that most plans can also offer a Roth 401(k) option.
In some instances, a Roth 401(k) may provide more benefits than a traditional 401(k), and could give you a leg-up in attracting top-level talent. Let's explore the ins and outs of Roth 401(k)s, and how they can benefit you and your employees.
The key differences
Both Roth 401(k)s and traditional 401(k) accounts are vehicles for your employees to save toward retirement. Where the two plans differ is in their treatment of taxes.
With a traditional 401(k), contributions come out of each paycheck pre-tax, which means taxes are owed only when the money is withdrawn, typically at retirement. Finance expert Suze Orman explains the instant gratification that drives the appeal of the traditional 401(k), "There is an upfront tax break when you save in a traditional 401(k) that you don't get with a Roth 401(k). Every dollar you contribute to a traditional account reduces your taxable income for that year."
"But money you put into a Roth account is made with after-tax dollars," Orman continues. With a Roth 401(k), the key benefit comes in the withdrawals, which are tax-free when the qualifications are met. "The prospect of no taxes in retirement on your retirement withdrawals is well worth considering."
Deciding how to contribute
For most participants, the decision to contribute to a traditional or Roth 401(k) account is a matter of comparing taxes you are paying today with projected taxes in the future.
If participants are paying lower taxes today than they think they will be in the future, they should seriously consider contributing to a Roth 401(k). Daily Finance explains that when you are in a lower tax bracket, the benefit of income tax deferral from a traditional 401(k) plan contributions is minimal. Using a Roth 401(k), participants may pay more in taxes now, but may save more for retirement in the long run. If they think that they’re currently in a high tax portion of their career, they may want to contribute to a traditional 401(k).
Blending the two
Tax planners also weigh in on this discussion. Having a mix of taxable and non-taxable income sources in retirement has its benefits. Roth balances are not taxed upon withdrawal so even if participants are paying fairly high taxes there may be a potential to make use of a Roth benefit mid-career.
As always, situations vary, so it's a very good idea to consult a qualified investment advisor and tax planner whenever making financial plans.
Can you still match with a Roth 401(k)?
Yes, matching is still applicable just like with a traditional 401(k). According to US Money, the company contribution is pre-tax and will go in your traditional 401(k). So by contributing to the Roth 401(k), participants will have some funds in the tax-free bucket and some in the pre-tax bucket.
Making the choice
Adding a Roth 401(k) option into your 401(k) plan may offer you and your employees the choice and flexibility you’re looking for in your company’s retirement benefits.
When considering a Roth 401(k), it’s important to do your research. Consult with plan providers, as well as tax and financial advisors, who should be able to explain which plan options best fit your needs.