RETIREMENT PLANNING
Roth 401(k) vs Roth IRA
written by Mike Ballew|November 24, 2019
When it comes to a head-to-head matchup between a Roth 401(k) and a Roth IRA, there’s really no competition. It’s an 18-wheeler vs. a Smart Car. It's the Biltmore compared to a doll house. The New England Patriots vs. St. Francis of Assisi Convent. The Roth 401(k) has no income restrictions and significantly higher contribution limits; it crushes the Roth IRA.
Let’s look at Roth IRA income limits. Singles earning more than $161,000 and married couples with a combined income greater than $240,000 are ineligible for Roth IRAs. So are married individuals earning more than $10,000 who file their taxes separately.
You have to ask, what was the IRS thinking when they made up that last rule? If somebody is making $10,000 a year, are they really going to invest in a Roth IRA? What does that even look like? “Hmmm, let’s see. Get a Roth IRA and starve to death, or keep living? What to do, what to do?"
The other advantage of a Roth 401(k) over a Roth IRA is much higher contribution limits. With a Roth IRA, you can only contribute $7,000 per year ($8,000 for those age 50 and older). The contribution limit for a Roth 401(k) is $23,000 per year ($30,500 for those age 50 and up) – the same as a traditional 401(k). There is just no getting around it, a Roth 401(k) is [choose your decade]:
1920s: The bees knees!
1930s: The cat’s meow!
1940s: Killer diller!
1950s: Nifty!
1960s: Groovy!
1970s: Far out!
1980s: Totally awesome!
1990s: Fly!
2000s: Sweet!
2010s: Cool!
The Taxman on Steroids
If you think taxes are bad now, just wait. They could get a whole lot worse. A day of reckoning is coming when we will be held to account for the financial sins of our forefathers. We’re talking about the national debt, which as you can see at U.S. National Debt Clock is completely out of control.
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Pay Me Now or Pay Me Later
The primary difference between a traditional 401(k) and a Roth 401(k) is when income taxes are paid. With a traditional 401(k), you don’t pay any tax on contributions made to the plan. Then when you use the money in retirement, you have to pay tax on both your original contributions and any investment growth.
A Roth 401(k) works exactly the opposite. You pay tax on plan contributions, then when you use the money in retirement, you don’t have to pay tax on your original contributions or the investment growth. It’s tax-free growth! Such beautiful words have not been uttered since “free beer!"
Converting a Traditional 401(k) to a Roth 401(k)
While it is possible to convert an existing traditional 401(k) into a Roth 401(k), it is not necessarily a good idea. You have never paid income tax on the money that you contributed to a traditional 401(k). If you convert it to a Roth 401(k), you will owe taxes on the entire amount at the time of conversion. For example, let’s say you’re in the 22% tax bracket and you have $100,000 in a traditional 401(k). If you convert it to a Roth 401(k), you will owe $22,000* in taxes. It doesn’t come with a convenient monthly payment plan. The payment plan is get out your pocketbook and write a check for $22,000. It could even bump you into a higher tax bracket, in which case you would owe even more taxes.
Paying the $22,000 tax bill out of the newly-converted Roth 401(k) would be a bad idea. Your nest egg might never recover from that kind of hit. You would miss out on too much compound investment returns to be worth it.
The best path forward is likely to leave your traditional 401(k) plan as is and start a new Roth 401(k). You can have both. Let your traditional plan continue to grow while shifting all your contributions to the Roth 401(k). Your employer will continue to provide matching contributions.
Last Call
If your employer offers a Roth 401(k), you owe it to yourself to check it out. Putting your money in a Roth 401(k) could pay off handsomely when you retire. While your retired friends are complaining about all the taxes they have to pay, you can chuckle and say you don’t pay any taxes.
*Approximate figure, actual amount would be less based on effective tax rate.
Photo credit: PixabayThe Eggstack Blog will never post an article influenced by an outside company or advertiser. Our mission is to help you overcome uncertainty about retirement planning and inspire confidence in your financial future.
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