Investments

Take advantage of Roth 401k

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by Charlie Evans
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Introducing the Roth 401k

A relatively new program that was recently introduced by my employer is the Roth 401k. It is similar to a Roth IRA where contributions are made with after-tax money. Both my wife and I already have Roth IRA accounts but we stopped contributing because our income exceeds the income limit. Roth IRA income limits start at $137,000 single or $196,000 married. This is where the Roth 401k program can help fill in that void that has been missing from my investments in the last few years.

What is Roth 401k and how does it work

The Roth 401k is an employer-provided savings plan that was introduced in 2006. Some employers offer both traditional 401k and Roth 401k programs so it is best to check with your employer. Like a Roth IRA, contributions are made with after-tax money where investment returns can be withdrawn tax-free in the future after age 59 ½. The Roth 401k counts towards the traditional 401k contribution limit of $19,500 for tax year 2020 or $26,000 for those 50 or older.

Mo Money Mo Problems

As mentioned before, my wife and I stopped contributing to our Roth IRA plans because we hit the income limit. A problem with making more money (if you can call that a problem) is the Roth IRA does not allow contributions if your income exceeds $137,000 for single filers or $196,000 for married. The Roth 401k does not impose any income limits. It is essentially the same as Roth IRA but is only accessible if your employer provides a Roth 401k program. This is major advantage of being “Barista FIRE” and staying employed. Wahoo!

Benefits of Roth 401k

Here is a summary of the Roth 401k key points:

The Roth 401k’s annual contribution limit is included with the traditional 401k limit of $19,500 for tax year 2020 or $26,000 for those 50 or older.
Unlike a traditional Roth IRA, there are no income limits when contributing to a Roth 401k.
Investment returns are tax-free for Roth 401k.
Distributions for Roth 401k can begin when two conditions are met:
1. person is age 59 ½ or older
2. Roth 401k account was opened at least 5-years
Roth 401k distributions must begin no later than age 72.

Can I contribute to both 401k and Roth 401k

I contribute to both my traditional 401k and Roth 401k. I have always made max contributions to my 401k however, I only started contributing to my Roth 401k. The Roth 401k is an employer-provided savings plan that was only offered to me recently by my employer in 2018. Most employers offer the traditional 401k, however not all employers offer the Roth 401k program so it is best to check with your employer.

The Roth 401k counts towards the traditional 401k contribution limit of $19,500 for tax year 2020 or $26,000 for those 50 or older. My advice is to split your contributions across a traditional 401k and Roth 401k so that you can maximize the amount of employer match. This strategy works especially well for high-earning Silicon Valley software engineers whose average base salary is north of $120,000.

Maximize your 401k employer match

I have already written about taking advantage of your company’s 401k matching contribution. Early in my career I would reach the maximum 401k contribution limit as quickly as possible before reaching the end of the year. I realized this was a poor strategy because I was not maximizing my employer match. Reaching the 401k contribution limit too soon means your employer would stop paying the match per month. Do not make this mistake of contributing to your 401k too aggressively! Instead, reduce your 401k contribution limit to the “Ideal 401k Contribution” so as to maximize the amount of employer match. The best way to ensure the employer match is maxed is to stretch your contributions across 12 months.

Related Post: What Does Employer Match Mean

Most employers that offer a match program offer between 3% to 6% at 50% or 100% match to the traditional 401k. The employer match is calculated by multiplying the match percentages against your pre-tax salary.

For example, let’s pretend John Doe has a base salary of $100,000.
His employer pays 50% match on the first 6% of your salary. The max employer contribution is $100,000 x 6% x 50% = $3,000.
In order to find the “Ideal 401k Contribution”, take the max annual contribution limit of $19,500 (year 2020) and divide by base salary. For John Doe in the year 2020, this would be $19,500/$100,000 = 20%.

A contribution higher than the “Ideal 401k Contribution” would result in taking less than the max employer contribution.

Let’s pretend John Doe decides to make 25% contribution to his 401k. This would result an employee match of only $2,500 which is $500 less than the maximum employer contribution of $3,000 he was eligible for.

Is Roth 401k better than 401k

Deciding between investing in a traditional 401k and Roth 401k is an individual choice. I would recommend investing in both especially for high-earning Silicon Valley software engineers whose average base salary is north of $120,000. My wife and I stopped contributing to our Roth IRA plans because we hit the Roth IRA income limits. The Roth 401k does not impose any income limits. Let’s review the key points:

The traditional 401k plan allows you to make contributions with pre-tax dollars so that you don’t pay taxes on money you contribute.
The Roth 401k plan allows you to make contributions with after-tax dollars so you won’t enjoy a tax break today but after retirement.
Employee match contribution is usually applied towards traditional 401k and not the Roth 401k.
Both plans have a 10 percent penalty assessed for early withdrawal, with penalty-free withdrawals beginning at age 59 ½.
Both plans are subject to required minimum distributions (RMDs), meaning after age 72 you have to take a distribution annually.

Retirement Cash Flow

Another aspect to debate over is how much tax you anticipate paying in retirement when deciding between if a traditional 401k or a Roth 401k is better. A high-income Silicon Valley software engineer is probably paying a marginal tax rate of 32% for all cash flow dollars after $207,350 (2020 Federal Tax limit). However, during retirement, I would imagine after age 67 that he/she will have a much lower cash flow. The cash flow would be from Social Security payments and a Required Minimum Distribution from a traditional 401k. A good strategy would be to withdraw only up to the marginal tax limit. For example, the limit for 22% tax bracket is $85,525 for a single filer or $171,050 for married. Therefore the pre-tax dollars from a traditional 401k would be subjected to the marginal tax bracket of 22%.

Age 67 (single)
Social Security about $4,000 per month or $48,000 annual
To stay within 22% Federal income limit for single filer in year 2020, take the upper limit and subtract off the Social Security annual amount.
$85,525 – $48,000 = $37,525
Required Minimum Distribution starts after age 72

Quick Summary

The Roth 401k plan is an employer-program that allows me to make contributions with after-tax dollars with no income limits. Both my wife and I stopped contributing to our Roth IRA because our income exceeds the Roth IRA income limits.
The Roth 401k counts towards the traditional 401k contribution limit of $19,500 for tax year 2020 or $26,000 for those 50 or older.
Employee match contribution is usually applied towards traditional 401k and not the Roth 401k.

Does your employer have a Roth 401k plan? What are your thoughts about contributing to both traditional 401k and Roth 401k? Let me know in the comments.

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Disclaimer: This article is provided for general information and illustration purposes only. Nothing contained in the material constitutes tax advice, a recommendation for purchase or sale of any security, or investment advisory services.

Take advantage of Roth 401k

Introducing the Roth 401k