Another benefit of the Roth is one many overlook. This is the ability to fund a Roth 401k regardless of your income. High income earners, even millionaires, can fund a Roth 401k if their plan offers it.
I know many of you are reading this and saying “Josh, you’ve really lost it now. Why on earth would a high-income earner want to fund a Roth with after-tax money when she is in a high tax bracket?”
To which I say “Even after reading this far in this book you still doubt the power of the Roth?”
First, let me explain the basics of a 401k plan. There are three parts:
Elective deferrals are the money you choose to forgo from your paycheck in order for it to go into your retirement account. You have one of two choices for where to put this money, the tax-deferred, i.e., the Traditional 401k or the tax free, the Roth 401k.
The money you contribute to the Traditional side reduces your taxable income in that year by the amount you deferred (see chapter 7). Whereas Roth contributions do not reduce your current income.
The second part of your 401k plan is the employer contributions. Employer contributions go entirely to the Traditional side even if you put your own money into the Roth side. You don’t pay any tax on the employer contributions until you make a withdrawal from the account.
Finally, your 401k consists of the profit sharing contribution your employer may offer. These contributions, if any are made, also go into the Traditional side of the ledger.
Some firms have significant profit-sharing contributions, many have nothing. So, don’t get too caught up on this. But if your firm does offer a decent profit sharing contribution on top of an employer match you may see the tax-deferred side grow quite large.
Given every penny of your employer contributions goes to the pre-tax side, I find this to be an incentive to put your own money into the Roth because of future tax hedging strategies.
If you have assets in the tax free (Roth) side and assets in the tax-deferred (Traditional) side, you have more flexibility in how to deal with future tax laws.
Situations change folks. The best way to deal with changing times is to be nimble and also not have all your eggs in one basket. Everyone knows diversification of investments makes sense, well, diversification of tax strategies does too.
Let’s say your salary is $100,000. But you elect to defer $15,000 of that salary into the Traditional 401k. Thus your taxable salary this year is $85,000.
When you reach the age of 70.5 you will be required to take a portion of that $15,000, and whatever growth you have, as taxable distributions. Again, you’re only deferring the tax until a later date, you haven’t eliminated it.
If, instead of deferring that $15,000, you funded your Roth 401k you’ll pay tax on the entire $100,000 salary you earned that year. But that $15,000 and whatever growth it earns will never be taxed again.
Is it worth it? Here’s a table to show you how much that extra $15,000 of income will cost you in taxes in the year you contribute to the Roth 401k.
Tax Bracket
Tax on $15,000
10%
$1,500
12%
$1,800
22%
$3,300
24%
$3,600
32%
$4,800
35%
$5,250
37%
$5,550
Table 29
As you can see, if you are in the 37% bracket you will need to decide if it is worth it to pay an extra $5,550 now to avoid any taxes in the future to yourself, your spouse and ultimately your kids and grandkids?
You kn
