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Younger People Taking Advantage of Roth 401ks


Younger People Taking Advantage of Roth 401ks

Roth 401ks are increasingly popular with young people. In a recent Wells Fargo survey, in the first quarter of this year, nearly 17% of participants under age 30 contributed to a Roth 401k, up from 15.2% a year ago, as compared to 4% of participants in their 60s. In addition, overall, the number of people with access to a Roth 401k increased by 5.3%.

Roth 401ks have been around since 2006 and people now seem to be checking them out, especially younger people. If however, Roth 401ks are a bit of a mystery to you, here are a few things to get you started on your path to understanding.

What can a Roth 401k do for you?

There are several reasons to get excited about a Roth 401k. One of the main advantages is that there is no income limitation in order to participate. Participants are able to contribute as much as $17,500 in 2013 and an additional $5,500 in “catch-up” provisions for those who are age 50 or older. Most employers also provide a matching contribution to the employee's contribution, which average 3% across many industries, says Abigail Gunderson, a certified financial planner with Tanglewood Wealth Management.

Another big plus is that qualified distributions are tax-free. This means earnings are allowed to accumulate over the years free of regular income or capital gains taxes, thus providing more retirement income.

Although a Roth 401k requires that distributions begin no later than age 70 ½, similar to traditional 401ks, a Roth 401k could be rolled into a Roth IRA. What's the advantage of doing that? “There is no requirement of a Roth IRA to start making distributions at any age. If the owner has other sources of income, these funds can continue to accumulate potentially tax-free throughout the person's lifetime. This can serve as an effective estate planning tool, as well, since the assets can grow for many years during a person's retirement and eventually be passed on to his or her heirs,” explains Gunderson.

Roth 401k ideal for young people

The question though, is why are young people in particular going for Roth 401ks? The Roth 401k makes a great deal of sense for younger investors primarily because of the power of compounding. “Having assets grow for 20-30 years without any taxes along the way or upon distribution is an extremely powerful tool,” says Brad Bofford, managing partner at Financial Principles.

Additionally, he says, one can argue that there is a higher likelihood that the investor will be in a higher tax bracket later in their career, so it's okay to forgo the tax deduction today at a lower rate. Then too, he says, there is a general consensus that tax rates will continue to rise overall, so one is hedging by paying taxes at a lower rate on a lesser amount of money today.

“Younger employees have a long runway for investing, so the tax benefit can be quite substantial,” says Laurie Nordquist, director of Wells Fargo Institutional Retirement and Trust.

Advantages for older workers too

While young people in particular have much to gain from a Roth 401k, others can benefit too.

“Both younger and older investors may benefit from a Roth 401k, it really depends on what the older investors' goals are for retirement and their heirs, and what they believe may happen to their tax bracket later in life. Some retirees may be faced with higher taxes in retirement than while they were working, given the complexity of the tax system, so it really depends on several factors,” says Jerry Korabik, a financial advisor with Savant Capital Management.

Know the facts

Like always, there are some myths or misconceptions. “Sometimes employees think that if they put money into a Roth 401k account they might not get an available matching contribution from the employer. The matching formula is usually based on how much money you put into the plan, not which 'bucket' you put the money into,” says Joseph Creal, a financial consultant with Cambridge Consulting group.

You also need to be careful when you transfer Roth 401k money out from a plan if you leave your employer. “You may need to roll money into proper IRA buckets to avoid a tax nightmare,” says Creal.

Know too, that in order to qualify for tax-free withdrawals, the account must be funded for at least five years and the distribution must be for one of the following – disability, separation from service, death or attainment of age 59 ½, says Bob Gavlak, a wealth advisor with Strategic Wealth Partners.

Mostly though says Leonard Wright, CPA and co-host of the radio show, Financial Fridays, “New entrants to the work force need to save in a Roth 401k – there's tax free growth with little tax sacrifice.”



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Comments
15 Comments.
Comment #1 by Anonymous posted on
Anonymous
I believe Roth IRA's first became available in 2008 not 2006.

1
Comment #2 by Anonymous posted on
Anonymous
Disregard above. I was thinking of Roth IRA's and meant 1998. It was 2006 for Roth 401K's. ME BAD

4
Comment #3 by Anonymous posted on
Anonymous
Seems like a good way for young workers start building an emergency fund and save for retirement at the same time. If I was just starting out I could see myself doing this given contributions (not earnings) can be withdrawn at any time for any reason.

http://www.bogleheads.org/wiki/Roth_IRA_as_an_emergency_fund

 

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Comment #4 by Anonymous posted on
Anonymous
Just wait until the tax man sees the amount of Roth money saved and taxes lost.  He'll renege on the promise of "tax-free qualified distributions".  There's already quite a few restrictions for a "qualified distributions".  There will be more coming.

 

 

 



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Comment #5 by Anonymous posted on
Anonymous
Roth IRA's are a good planning tool for older folks also. It is there for a tax free withdrawal if needed if the RMD's are not enough in a given year and if not needed it is there for a tax free inheritance. We were able to contribute to a Roth IRA for 10 years before retirement and I was able to do a Roth IRA for 9 months before retirement. We have not had to touch any of it so far. For young people it is a great tool because usually they are in a low tax bracket in their begininng years of working and the money also has a longer time period for compounding. 

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Comment #6 by Anonymous posted on
Anonymous
I believe teh best answer is "It depends".  The roth 401k option is better if taxes are more in the future, and with the promise of $120 trillion dollars in unfunded liabilities that the baby boomer generation promised themselves, I can guarantee taxes will be higher in the future.  In fact, this year there is a medicare surcharge of 0.9% for every dollar over 250k for a couple and 200k for singles.

 

The G-men live the roth 401k because they collect the taxes now.

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Comment #7 by paoli2 posted on
paoli2
I never did do the Roth because I didn't understand the way it worked.  I could not see the government letting people save money "tax free" and then withdrawing it later as they wanted and still not pay taxes on it.  "When" do you pay taxes on it??  It just doesn't make sense to me even today.

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Comment #8 by pua posted on
pua
Paoli2 asked when do you pay taxes on a Roth?  The answer is, you already paid the taxes.  The money you put in is "after-tax" dollars, meaning that you paid the taxes in the year you earned the money.  You never deducted those dollars from your taxable income.  So you will never owe taxes on those dollars because you already paid the taxes.  What you might wonder about is whether you'll ever owe taxes on the capital gains or the interest earned over the years.  And that's where the tax break comes in.  Roth lets you keep the capital gains or interest totally tax free.  Years and years of capital gains or interest is all tax free, not only each year as you earn it, but also at the time you withdraw it.  The government might sometime change its mind and might start making you pay tax on it, but I think they could only do that for capital gains or interest earned after they change the law, never for what you've earned before they change the law.  Because the Constitution says Congress shall make no ex-post-facto law, meaning that they can change the law going forward, but they cannot retroactively apply the change to anything that happened before they made the change.

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Comment #9 by paoli2 posted on
paoli2
PUA:  Thanks for the education but my brain seems to be on vacation today.  Isn't the money we put in out other IRAs after tax dollars too?  It's been so long ago that we put the money in and I just don't remember.  If it was money we rolled over from a company plan that would have been "pre-tax" dollars?? I am still confused but that is not new for me on a Sunday.  Maybe by Monday my brain will be working again.  Thanks for the help.

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Comment #10 by Jake (anonymous) posted on
Jake
Can you just start up a Roth 401k like you can a Roth IRA? I have a (traditional?) 401k through my employer, a Roth IRA from my last job which did not have a retirement plan, and a Rollover IRA from a previous job's 401k which I left. I know that I could not have continued contributing to my old employer's 401k and I could not join my new employer's 401k until I met eligibility requirements but I was able to start a Roth IRA with Vanguard no problem. How does one find out if they can create or join a Roth 401k? Could I apply my company's 401k match to the Roth 401k instead?

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Comment #11 by Anonymous posted on
Anonymous
401k match is always pretax, even if you do the roth 401k.  So for a younger worker that's doing the roth 401k (already taxed), they would still be building a bucket of pretax money from the match.

1
Comment #12 by Anonymous posted on
Anonymous
pua #8:

You said:

"Because the Constitution says Congress shall make no ex-post-facto law, meaning that they can change the law going forward, but they cannot retroactively apply the change to anything that happened before they made the change"

Where have you been lately?  Congress does this all the time.

 

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Comment #13 by Anonymous posted on
Anonymous
Regarding "One of the main advantages is that there is no income limitation in order to participate", name something in the realm of IRA or 401(k) that does have an income limitation.  There isn't one, so this is a non-advantage.

Contributing to a Roth IRA used to have an income limit, but this was effectively eliminated when the income limits on Roth conversions was removed.  Simply contribute to a non-deductable conventional IRA and immediately convert it to a Roth IRA.  Some call this a "backdoor Roth".

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Comment #14 by Anonymous posted on
Anonymous
paoli2 #9

 

What is a difference between a Roth IRA and a non-deductible Traditional IRA? In both Roth IRA and non-deductible Traditional IRA, contributions are non-deductible, meaning that you fund them with after-tax money. The major difference comes from the way earnings are taxed. Earnings are taxed as ordinary income if you withdraw them from a non-deductible Traditional IRA. In contrast, earnings are tax free if you withdraw them from a Roth IRA.

http://www.bogleheads.org/wiki/Non-deductible_Traditional_IRA

 

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Comment #15 by Anonymous posted on
Anonymous
Because "traditional IRAs" are deductible if you fall in certain income limits and subject to whether you have an employer plan or not.

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