More and more companies today are offering a Roth 401(k) option as part of their retirement plans. If your employer is among them, and you've decided to go the Roth route, here are six ways to maximize your returns.
- The earlier in your career that you start contributing to a Roth 401(k), the better.
- You can fund both a Roth 401(k) and a Roth IRA, which has its own advantages.
- Roth 401(k)s are subject to required minimum distributions at age 70½, but you can avoid that by moving your Roth 401(k) money to a Roth IRA, letting it continue to grow.
1. Start Early
As with many investments, the sooner you start, the better your eventual returns are likely to be. An added advantage of opening a Roth 401(k) as early as possible in your career is that, unlike a traditional IRA, you fund it with after-tax income and pay taxes on that money today, rather than later in life when you may be in a higher marginal tax bracket. Your tax rate is generally lowest when you’re young and early in your career. Once you're further along and have some received promotions and raises, your tax rate will probably be higher.
2. Hedge Your Bets
Nobody knows what will happen in the economy by the time your retirement date arrives. While it might not be something you want to think about, an adverse event, such as a job loss, could put you in a lower tax bracket than you are right now.
In the investment world, a hedge is like an insurance policy; it removes a certain amount of risk. In this case, if you split your retirement funds between a traditional 401(k) and Roth 401(k), you would pay half the taxes now, at what should be the lower tax rate, and half when you retire, when rates could be either higher or lower.
If your employer matches any or all of your Roth 401(k) contributions, it has to do that in a separate, pre-tax account, so there’s a good chance you’ll end up with both Roth and traditional 401(k)s anyway.
3. Know Your Limits
If you're under age 50, you can contribute an annual maximum of $19,000 to your 401(k) accounts (as of 2019). If you're 50 or over, you're allowed an additional catch-up contribution of $6,000, for a maximum of $25,000 (as of 2019). You can split your contributions between a Roth and traditional 401(k), but your total contribution can't exceed $19,000 or $25,000, depending on your age.
4. Fund a Roth IRA, Too
You can contribute to both a Roth 401(k) and a separate Roth IRA, as long as you don't exceed the income limits on the latter. The rules for Roth IRAs are much the same as for Roth 401(k)s, although contribution limits are lower—$6,000 a year if you're under 50, $7,000 if you're 50 or over (in 2019). You can also contribute to a Roth IRA as late as the April tax deadline. For example, you can make a contribution to your 2019 IRA through April 15, 2020. Your 2019 Roth 401(k) contribution must be made by December 31, 2019.
The Roth IRA has some other benefits worth considering. You'll have more investment options than your employer might offer, and the rules for withdrawing funds are more relaxed. You are generally able to withdraw your contributions (but not their earnings) at any time and pay zero taxes or penalties. That’s not the point of a retirement account, but knowing you could get out some money in an emergency might be reassuring.
5. Plan for Withdrawals—or Not
Once you reach age 70½, you must begin to take required minimum distributions (RMDs) from both traditional and Roth 401(k)s. However, you can avoid this problem by moving your Roth 401(k) funds to a Roth IRA. Roth IRAs don't require RMDs during the account holder's lifetime. So if you don't need the cash to cover your living costs, you can let that money continue to grow well into your retirement years and even pass, untouched, to your heirs.
Note that if you're still employed at age 70½, you do not have to take RMDs from either a Roth or a traditional 401(k) at the company where you work. One difference if you do end up taking RMDs: Distributions from a traditional 401(k) are taxable at your current income tax rate, but the Roth 401(k) money is not (because you contributed from after-tax funds).
Review your account periodically to check how your investments are performing and whether your asset allocation is still on track.
6. Don’t Forget About It
Employer-sponsored retirement plans are easy to neglect. Many people just let their account statements pile up unopened. As the years go by, they may have little knowledge of their account balances or how their various investments are performing. They may not even remember exactly what they're invested in.
A retirement account isn’t meant for constant changes, of course. But at least once a year, it's worth evaluating the funds you chose. If they’re constantly underperforming, it might be time for a change. Or, your asset allocation may have gotten out of whack, so that you have too much money in one category (such as stocks) and too little in another (such as bonds).
If you’re not well-versed in the investment world, it’s probably best to get the advice of a non-biased financial professional, such as a fee-only financial planner.