How to Use a Roth 401(k) for Smart Retirement Planning

If you like the idea of a Roth IRA, you’ll love the idea of a Roth 401(k

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If you like the idea of a Roth IRA, you’ll love the idea of a Roth 401(k). This plan, offered by many employers, allows you to create a tax-free retirement income stream down the road. Here’s how it works:

Unlike the traditional 401(k), contributions to your Roth 401(k) are not deductible. That means you don’t get a tax break when you make the contribution. So during the years you make contributions, your taxes won’t be as low as they otherwise would be had you contributed to a typical 401(k) plan. Why would anyone want to do that?

First, while you don’t get an immediate tax deduction for your contributions, the money grows tax-free and you won’t pay any taxes if and when you take distributions either. That my friend is a spicy meatball.

Also, with traditional 401(k) plans, you must start taking distributions (ending the tax deferred growth) once you reach age 70 ½ or retire (whichever is later). With the Roth 401(k), you never have to take distributions. This benefit can be especially powerful if you plan on leaving retirement assets to your heirs and having them taking advantage of an Inherited IRA.

The Roth 401(k) can also be especially effective when it comes to maximizing Social Security benefits. If you are currently receiving Social Security benefits, half of those benefits might be taxable. That’s the case if your (joint) adjusted gross income plus half your SSI plus tax-free interest falls between $32,000 and $44,000. And if your AGI is greater than $44,000, 85 percent of your SSI will be subject to tax.

If you have a regular 401(k), you will be forced at some point to take that Required Minimum Distribution. And taking that RMD might be just enough to trigger a tax on your Social Security income as noted above. By having your retirement funds in a Roth 401(k), you will never be forced to take a distribution. As such, you might just be able to keep your Social Security benefits out of the cross hairs of the IRS.

As I mentioned, the greatest attraction of the Roth 401(k) is that you will have no tax liability when and if you make distributions in the future. The money grows tax free and you can make withdrawals tax free as well.

Does this mean you should convert your existing 401(k) to a Roth 401(k)?

I don’t think so. If you do, you’ll have to declare everything you converted as taxable income at the time you make the conversion. It’s probably smarter to simply make some or all of your new contributions into the Roth 401(k) if one is available at work.

How are distributions made?

You can withdraw money from your Roth 401(k) once you’ve had the money in the account for at least five years and you’ve reached 59 ½. If you separate from service at 55 or older, you can also make a tax-free (and penalty free) withdrawal even if you haven’t been on the job for five years.

What if your employer doesn’t offer the 401(k) Roth?

If this plan appeals to you, talk it over with a few of your co-workers. The cost of implementing such a plan is minimal. Your employer should welcome the opportunity to provide an added benefit for the staff.

Do you have a Roth 401(k)? Are you taking advantage of it?

Neal Frankle is a Certified Financial Planner in Los Angeles and also an authority blogger at One of his most interesting recent posts was his Scottrade Review.