What Is a Roth 401(k)? Should You Get One?

In this episode of Coffee with Carl, attorney Carl Zoellner explains the basics of Roth 401(k)s for retirement planning.

Updated October 27, 2020

In previous episodes of Coffee with Carl, I’ve discussed different retirement planning options. One retirement planning vehicle that I haven’t covered yet is the Roth 401(k). So, let’s go over it.

Traditional vs. Roth Retirement Accounts

Retirement accounts come in two “flavors”: traditional or Roth. Traditional retirement accounts are funded with pre-tax dollars, while Roth retirement accounts — both IRA and 401(k) — are funded with post-tax dollars. This means that, after you’ve already paid tax on the income, you then contribute those after-tax dollars to the Roth account.

Calculating Is Key

With any retirement plan, the first step is to calculate. What makes sense? What is your current income bracket, and how does that compare to your anticipated future income bracket during your retirement years?

If you’re in a lower income bracket right now, it may make sense to use a Roth account rather than a traditional retirement account. This is because, if you anticipate your income tax bracket being higher during your retirement years, it doesn’t help you to defer the tax to a higher bracket. With traditional retirement accounts, it may make sense to contribute with pre-tax dollars if you’re in a higher tax bracket now, but that relies on the assumption that you’ll be at a lower income bracket when you get to retirement. Ultimately, retirement planning’s first step is to calculate.

IRAs vs. 401(k)s

The Roth 401(k) can be a useful tool with the right planning, especially for small business owners. You can have your own solo 401(k) set up from your business, but also be aware that solo 401(k)s offer a Roth option within the same account. This can allow you to do things like plan conversions from traditional to Roth within your own solo 401(k).

This is one of the benefits of 401(k)s over IRAs, among others. Other potential pitfalls with IRAs that aren’t necessarily relevant to 401(k)s include prohibited transactions and UDFI. With 401(k)s, your risk of loss is lower. If you create a prohibited transaction in an IRA, you risk disqualifying your entire account. With a 401(k), the loss associated with a prohibited transaction would be limited to that transaction. Furthermore, 401(k)s offer a bit more flexibility in investing in a project or purchase with debt. In an IRA, using debt to finance a project would result in being subject to UBIT or UDFI. In a 401(k), those provisions don’t exist.

Another benefit of using a 401(k) for retirement planning over an IRA is a significantly higher contribution limit. With IRAs, your annual contributions are capped at $6,000. With 401(k)s, your annual contribution is capped at $57,000. There are some options with IRAs that could increase your contribution limits, but those veer more towards the SEP-IRA.

The Takeaway

If you’re considering whether to start a Roth account, my recommendation would be to use a 401(k) instead of an IRA to allow yourself that added flexibility. If you have any questions about your retirement game plan, our Senior Advisors would be happy to discuss the best strategy for you with a complimentary Strategy Session. You can schedule online or by calling 888.871.8535.

Watch as Carl provides a big-picture overview of Roth 401(k)s and how to effectively use this retirement planning tool.

Resources mentioned in this video:

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Got an idea for a future Coffee with Carl? Send it to Carl at cwc@andersonadvisors.com.

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