Why a Roth 401(k) Is Better for Millennial Savers
There are a number of benefits to saving for retirement in a 401(k), including the potential to lower your tax bill by deferring part of your salary into the plan or grow your savings faster through employer matching contributions. The only hitch is that when you retire and begin taking qualified distributions, the money you withdraw is subject to your regular income tax rate. (For more, see The 401(k) and Qualified Plans Tutorial.)
A Roth 401(k), on the other hand, takes a different approach to how savings are taxed. For Millennial workers, choosing a Roth plan over a traditional 401(k) offers some distinct advantages that make it worth a second look. (For more, see How Much Millennials Should Save to Retire Comfortably.)
How a Roth 401(k) Works
With a Roth 401(k), workers make elective deferrals into the plan up to the annual limit established by the IRS. For 2016 the maximum amount workers can save in their plan is $18,000. Contributions are made using after-tax dollars, which is the exact opposite of a traditional 401(k). That means you don't lower your income in the year that you make the contribution.
Once you reach age 59½, however, you can begin taking withdrawals from your Roth account penalty free, as long as the account’s been open for at least five years. The biggest difference, however, between a Roth and a traditional 401(k) is that distributions of earnings and contributions are also 100% tax free. (For more, see How to Minimize Taxes on 401(k) Withdrawals).
A Roth 401(k) Is a Hedge Against a Higher Tax Bracket
A traditional 401(k) offers an upfront tax break, because every dollar you contribute reduces your taxable income. For twentysomething savers, however, that benefit may not be all that significant if they’re not yet in a high tax bracket because they're at the early stages of their career. Over time, the tax-free growth and withdrawals permitted by a Roth 401(k) can prove to be more valuable.
Consider a 25-year-old who’s making $36,000 a year and chipping in 10% to his or her 401(k). Based on current salary and single filing status, said Millenial would fall into the 15% tax bracket. Now, assume that he or she continues saving that same $3,600 until retiring at age 65 in the 28% tax bracket. With a 7% annual return, a Roth 401(k) would, according to two different calculators we consulted, yield approximately either $17,630 or $18,460 more in retirement income annually than taking the traditional route, all of which would be tax free.
For Millennials who expect their income to increase down the line, waiting to take the tax break later makes more sense. In the meantime, twentysomethings can look for other ways to reduce their tax liability, such as claiming the Retirement Saver's Credit or deducting student loan interest.
Millennials Can Use a Roth to Sidestep RMDs
One drawback of saving in a 401(k) or a traditional IRA is having to take required minimum distributions (RMDs) starting at age 70½. Failing to take RMDs as scheduled can result in a 50% tax penalty of the amount you're required to withdraw. A Roth 401(k), however, makes it possible for Millennials to work around the RMD rule by rolling over that money into a Roth IRA.
As taxes have already been paid on the contributions they are converting, rollovers would be tax free as long as you're initiating a direct transfer between the accounts. You can roll a traditional 401(k) into a Roth IRA, which is called a Roth conversion, but because taxes are deferred Uncle Sam will expect a cut. If you're receiving Social Security benefits or supplementing your retirement income with an annuity or withdrawals from another IRA, being able to avoid RMDs allows the money you saved in your 401(k) to continue to grow.
The Bottom Line
A Roth 401(k) is beneficial to Millennials in more ways than one, especially where taxes are concerned. When comparing the merits of a Roth against a traditional 401(k), Millennials must weigh their long-term financial outlook against their current tax situation. If a bigger paycheck is in the future, a Roth has the edge when it comes to minimizing the tax bite in retirement.