What You Need to Know About a Roth 401(k)

You may already know what a 401(k) is, but do you know what a Roth 401(k) is? As the name would imply, a Roth 401(k) works in the same manner as a Roth IRA in that all contributions are made with after tax dollars. This is as opposed to pre-tax dollars like with a regular, or traditional, 401(k). So why would you want to consider a Roth 401(k)?

First of all, Roth 401(k)s are offered for many who make too much money to take advantage of a Roth IRA, provided their employer offers it. So, as there is a phase out limit with a Roth IRA in regards to contributions, there is no such thing with a Roth 401(k).

Additionally, a Roth 401(k) allows you to contribute the same amount to it as a traditional 401(k) does. The current number stands at $16,500 unless you are over the age of 50. In that case, you can contribute a total of $22,000.

If you feel that you have a sounds investment strategy, then a Roth 401(k) is perfect for you as opposed to a traditional. The main reason is that while you do make contributions with after tax dollars, those dollars grow tax free and are distributed tax free when you turn 59 ½. With a traditional 401(k) you would have to pay your current tax rate upon withdrawal. Therefore, if you think that your investment strategy will allow you a great deal of appreciation over the years, then you may want to enjoy all of that appreciation without ever paying a cent of tax on it.

The drawback of course, is that you do not get the tax break that you would with a traditional 401(k). But, those tax breaks could potentially pale in comparison to the gains that you could achieve as they are capped and gains are not.

As always, I recommend that you talk with your investment advisor about the pros and cons of a Roth 401(k) before you decide to open one or not. As I found with many of my clients when I was a stock broker, some circumstances call for the traditional and some call for the Roth, but each case needs to be examined thoroughly and individually.

Source: Aleksandra Todorova, Understanding the Roth 401(k), SmartMoney.com