If your employer offers a 401(k) plan, signing up for it is one of the smartest moves you can make on the retirement front. And these days, it's not uncommon to find a 401(k) plan that offers a Roth savings option. In fact, an estimated 70% of 401(k)s now have a Roth feature.
What does that mean to you? Traditional 401(k)s are funded with pre-tax dollars so that if you put $5,000 into yours this year, that's $5,000 of income you won't be taxed on. Roth 401(k)s, on the other hand, are funded with after-tax dollars, so there's no immediate savings to be reaped. That said, there are plenty of good reasons to save for retirement in a Roth 401(k). Here are three that might sway you to go this route.
1. Tax-free retirement withdrawals
Though traditional 401(k)s give you a tax break for contributing money, the flipside is that your withdrawals in retirement are taxed as ordinary income -- meaning, the highest rate you're liable for. This can be challenging from a financial planning standpoint, since you'll need to account for taxes when determining how much of your plan balance to withdraw year after year. Roth 401(k)s, on the other hand, allow for tax-free withdrawals, which means that once you're retired, that money is yours free and clear.
2. No income limits to participate
Like 401(k)s, IRAs also come in the traditional and Roth variety. Higher earners, however, are barred from funding a Roth IRA directly. This year, individual tax filers with income exceeding $137,000 and joint filers with income exceeding $203,000 don't get the option to contribute money to a Roth IRA. The good thing about Roth 401(k)s is that there are no income limits to worry about -- you can fund a Roth 401(k) even if you're bringing home a $1 million salary.
3. Higher contribution limits
One advantage of 401(k)s over IRAs in general is that they come with higher annual contribution limits. This year, you can put in up to $19,000 if you're under 50, and up to $25,000 if you're 50 or older. The result? You get a prime opportunity to amass some serious wealth.
Imagine you're 35 years old and want to retire in 30 years. If you were to max out your Roth 401(k) at the current limits, keeping in mind that they could easily rise over time, and you were to invest your savings at an average annual 7% return, which is a couple of percentage points below the stock market's average, you'd wind up with a whopping $1.93 million. Best of all, that entire sum would then be yours to use in retirement, without having to worry about the IRS snagging its share.
If your 401(k) plan comes with a Roth savings option, it pays to consider it, especially if you expect your tax rate to be higher in retirement than it is today. That said, if you can't afford to give up the immediate tax break you'd get by funding a traditional 401(k), consider spreading your savings out across both options. This way, you get the best of two worlds -- an up-front tax break today, and the option to take tax-free withdrawals when you're older and really need that flexibility.