401(k) Plans: Roth or Regular?

You’ve probably heard of a 401(k) but what about a Roth 401(k)? Not all employers offer the option but if they do should you take it? Here are the rules you need to know.

What’s the Difference?

There’s no difference in how you manage the account. The same options are available to both kinds of funds and the same investing rules apply, such as the importance of asset allocation and rebalancing.

The difference lies mostly in the tax treatment. All contributions made to a Roth 401(k) are taxed in the year they’re received; you make them with after-tax income. Contributions to a traditional 401(k) are taxable when the money is withdrawn during retirement. There are other tax differences that may apply to some individuals. A financial planner can help with these.

Which One Should I Pick?

The good news is that the way you choose between the Roth and traditional 401(k) is the same way you pick between the two IRAs. There are online calculators to help guide you in that choice. Google “Roth or traditional 401(k) calculator” and you’ll find multiple versions.

But it’s not enough to rely on a calculator. If you’re in a low tax bracket now and believe that you’ll be in a higher bracket when you retire, pick the Roth. If you’re early in your career, interest rates are likely to climb in your lifetime – pick the Roth.

Of course, no website, article or calculator can account for your individual financial situation. Ask an expert if you’re unsure.

Can You Have Both?

Yes, you can contribute to both a traditional and Roth 401(k). You are subject to a yearly contribution limit of $17,500 ($23,000 if you’re 50 or older). You can allocate your total amount in any way you would like between the two accounts.

Some financial advisers advise clients to split their contributions evenly between a Roth and traditional 401(k) so they don’t have to predict their future tax situation. This is a form of hedging

You Might Have Both, Anyway

If you elect a Roth 401(k), you are still eligible to receive matching funds from your employer. However, those funds can only go into a traditional 401(k).

No Income Restrictions for the Roth 401(k)

If you’re single and earn $127,000 or more – or married and earn $188,000 or more jointly – you cannot contribute to a Roth IRA. Those rules do not apply to a Roth 401(k).

When Can You Switch?

Employers who offer the Roth 401(k) have to give you an opportunity to switch at least once per year and have to inform you of those periods.  Once you switch to a Roth 401(k) you have until October 15 of the following year to revert back to the traditional 401(k) if you would like. Once that time period has expired, you may not switch.

The Bottom Line

A Roth 401(k) makes sense for employees early in their career or those who believe that they’ll be in a higher tax bracket later in life (see Strategies For Your Roth 401(k)). Like anything involving taxes, the rules are sometimes difficult to understand and highly individualized. Check with a trusted financial adviser before making a change. Anything involving retirement funds should involve a professional unless your level of financial knowledge is high.