Everyone’s hot on Roth IRAs, but there’s one drawback: There are income limits starting at $189,000 for a couple and $120,000 for an individual, which means higher earners must go with a traditional IRA or a backdoor Roth. It turns out, though, that those limits don’t apply to Roth 401(k)s—meaning you can get all the benefits with your employer plan and not worry about your income ceiling.
But it’s not just those high earners who stand to profit. Roth 401(k)s are appealing options for all workers. Like with a Roth IRA, contributions to a Roth 401(k) are done after the money is taxed, making withdrawals tax- and penalty-free, assuming you’re 59½ and have had the account for at least five years. But a bonus is that like a traditional 401(k), you can save up to $18,500 for 2018, and up to $24,500 if you’re age 50 or older, which are significantly higher than the $5,500 and $6,500 allowed in IRAs.
That’s great, you say, but investing in a Roth means you lose the tax benefit now, making it more beneficial for younger workers. And it’s true that younger workers, who tend to earn less, stand to gain more from decades of tax-free growth than an upfront deduction. But take a look at this chart from T. Rowe
Screenshot: T Rowe Price
The chart makes a lot of assumptions, including that each investor contributes $1,000 to either the Roth or traditional IRA, that they are in the 25 percent tax bracket and that there is a seven percent annualized return. And in almost every case, the Roth does better than the traditional, even for older workers.
“The benefits of tomorrow’s tax-free retirement withdrawals with a Roth IRA far outweigh the benefits of today’s tax-deduction and other possible benefits with a Traditional IRA,” Stuart Ritter, a senior financial analyst at T. Rowe Price, says in the report. “Even though the Roth IRA contribution doesn’t qualify for an income tax deduction, decades of compounding tax-free money can generate more spendable income in retirement.”
The same thinking applies to 401(k)s as well, as this example from Kiplinger, illustrates:
Tom and Elaine, both 45, contribute $5,000 to their 401(k) plans. Tom contributes to a traditional 401(k) plan, while Elaine contributes to a Roth. They continue to work into their seventies and don’t take withdrawals until they’re 75. If their tax rates and investment returns remain equal, Tom will end up with $27,404, after paying taxes on the withdrawal, while Elaine will have $38,061 tax-free (this example assumes a seven percent annual rate of return and a 28 percent tax bracket). Even if Tom invested the $1,400 in tax savings he enjoyed by investing pretax money in the taxable account, he’d still lag Elaine by $2,616.
And it’s not just that you could end up with more later on using a Roth; it’s also that withdrawals from a traditional account are treated as income, which could push you into a higher tax bracket later on, having big implications for the size of your Social Security check and your Medicare premiums.
Plus, with tax rates being as low as they’re likely to be for the foreseeable future, Roths are more appealing than ever.
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