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Roth 401(k) and 403(b) plans available since January 2006 offer substantial benefits to employees who are looking for ways to shelter income from taxes on a permanent basis. However, it can be difficult for employees to know whether they will come out ahead by selecting the Roth option in their plans instead of the traditional pretax contribution features.

Let's take a look at some of the benefits of the Roth feature and compare them to traditional retirement plans. (For background reading, see An Introduction to the Roth 401(k).)

How Does the Roth Feature Work Inside a 401(k) or 403(b) Plan?

Plans that offer the Roth alternative work much the same as traditional plans, except that the Roth portion of the plans is taxed similar to a Roth IRA, and only after-tax contributions are allowed in the Roth account. Similar to Roth IRAs, employees can withdraw their balances tax free, provided distributions are qualified. For this purpose, a qualified distribution is one that is taken after five years, with the five-year period beginning the first year that the Roth plan receives a contribution. The employee must also be either at least 59-1/2 years old or disabled. There are also rules for taking distributions after the IRA holder is deceased (see Inherited IRA and 401(k) Rules Explained).

The maximum contribution that can be made for 2017 is $18,000, plus the additional $6,000 catch-up contribution for employees who are at least age 50 by the end of the year (total: $24,000). However, only the employee's salary deferral contributions can be allocated to the Roth account; any matching contributions by the employer must be done as traditional pretax contributions.

Benefits (and Not) of the Roth Plan Feature

No income Limitations. One of the main advantages that Roth 401(k) and 403(b) plans offer is the freedom from income limitations on contributions that apply to Roth IRAs. These plans effectively provide a tax-free shelter for high-income earners that cannot be matched. In 2017, a corporate executive making $300,000 per year can shelter up to $18,000 ($24,000 if 50 or older) in a Roth 401(k) or 403(b) – but he or she would not be eligible to make any kind of contribution to a Roth IRA with such a high income level.

An $18,000 Roth contribution made annually for 20 years with a growth rate of 5% comes to more than $616,000. This is likely the largest tax-free pool of cash that the employee could accumulate under any circumstances. But the benefits of the Roth plan are not limited to high-income earners.

Lower-salaried employees can both contribute to their Roth 401(k) or 403(b) plans and still make contributions to a Roth IRA as long as their incomes do not exceed the threshold amount. For example, a rank-and-file employee earning $70,000 annually could contribute $18,000 to a Roth IRA and still put another $5,500 per year ($6,500 if 50 or older) into a Roth IRA. Given the same time horizon and return on capital as the executive, this employee would have more than $1 million tax-free to spend! There are few other types of investments or savings plan that can even come close to offering this kind of tax-free accumulation.

Your company must offer them. A real drawback to Roth 401(k) and Roth 403(b) plans is that they are only available for employees of companies that offer them.

If you're self-employed. Self-employed individuals can use these plans, too – and contribute even more each year: in 2017, the self-employed can contribute up to 25% of their net earnings from self employment up to $54,000, plus $6,000 more if age 50 or over) in a one-participant 401(k) account. Only $18,000 of this amount – $24,000 if making catch-up contributions – can be Roth contributions; the rest are traditional contributions, with different tax treatment at retirement. Work with a financial advisor on this to make sure you get this right and that you do the right kind of record-keeping. For more, see Retirement Plans for the Self-Employed.

Tax Treatment. Roth 401(k) and 403(b) plans have the same disadvantage as Roth IRAs:  Their contributions are made on an after-tax basis so there's no initial tax saving.

However, the flip side to this is that employees can then take a distribution of any size from their Roth balances in retirement without paying income tax on that money. Distributions from traditional IRAs and 401(k)s are taxed at the account holder's ordinary income tax rate, which can affect the taxability of their Social Security benefits and raise their tax bracket.

No RMDs. Furthermore, employees who roll over their plan balance into a Roth IRA will not have to worry about taking any kind of required minimum distribution (RMD). This simplicity is worth something in and of itself, especially for retirees who are not financially savvy and may struggle with understanding how their plan distributions impact their taxes in other areas. Read up on 6 Important Retirement Plan RMD Rules to get ahead of the game.

Beyond these issues, Roth accounts provide a deeper assurance that the employee has a future hedge against taxes, which becomes even more valuable if taxes increase. Roth accounts are quickly coming to represent the promised land for many retirement savers – a haven where the tax man cannot reach them, a place where government bureaucracy is shut out, an area of their lives that they alone control. (For related reading, see When Is a Roth IRA Conversion the Right Move?)

So Which Is Better: Roth or Traditional Accounts?

Some pundits would say that it is important to know whether you will be in a higher or lower tax bracket at retirement before you choose between a Roth or a Traditional plan. In many cases, though, this may not matter.

For example, Sally Saver is in the 28% tax bracket and works for an employer that offers a Roth 401(k). She dutifully saves $15,000 a year in her Roth account for 30 years. But because she is making after-tax contributions, her contributions are actually costing her $19,200 a year ($15,000 plus $4,200 in taxes because the amount is not tax deferred). Therefore, at the end of 30 years, she will have paid a total of $126,000 in taxes on her Roth contributions.

Meanwhile, her friend, Nancy Now, makes contributions to a traditional 401(k). Nancy is also in the 28% tax bracket and enjoys an annual tax reduction of $4,200 on her contributions, because they are made on a pretax basis. Therefore, she reduces her taxes by a total of $126,000 over 30 years. Assuming that both women earn an average of 9% on their investments, they will each have slightly more than $2 million in their plans by the time they retire.

Now assume that both Sally and Nancy begin drawing money from their plans at the end of the 30-year period, that they both drop down to the 15% tax bracket in retirement and draw $50,000 per year from their plans. Nancy must pay $7,500 per year on her distributions, while Sally pays nothing. If both women live for another 30 years, Nancy will have paid a total of $225,000 in taxes on her 401(k) distributions alone. Of course, these distributions will also likely trigger at least a partial tax on her Social Security benefits and may raise the rate at which any other income she receives is taxed. If Nancy has enough other income to stay in the 28% tax bracket, her taxes will soar to $420,000. 

The Bottom Line

This scenario is a telling example of the benefit that can be reaped by biting the bullet and paying taxes now instead of later. Although such variables as changes in tax brackets, longevity and investment performance must also be taken into account, the Roth account tends to beat the traditional plan in most scenarios.

Disciplined savings can change outcomes. By putting her money in a traditional 401(k), you'll remember that Nancy Now saved $4,200 a year in tax reductions. If she had invested those savings every year, she would have about $600,000 in additional after-tax savings after 30 years, assuming the same 9% rate of return.

So when you're deciding which type of 401(k) to invest in, one consideration is what you would do with the tax savings you get from making pretax contributions. To figure all this out and project future income, consult a financial advisor.

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