5 critical action steps every first-time homebuyer must know
David Bach’s
arrow First-Time Homebuyer Challenge
Get Access Now Learn More
By Sarah Max
April 8, 2016
Robert A. Di Ieso, Jr.

Q: My daughter makes $13,000 a year and saves 25% in her 401(k). I also help her fund a Roth IRA. If she switches to a Roth 401(k), how will that impact her take-home pay? And can she still contribute the max to her Roth IRA? — Paul

A: Switching from a traditional 401(k) to a Roth 401(k) is pretty much a “no brainer” for someone in your daughter’s situation, says Nancy Coutu, a certified financial planner and co-founder of Money Managers Financial Group in Oak Brook, Ill.

That’s because of what she pays in taxes now, and how that’s likely to change over time.

Contributions to a traditional 401(k) are made with pre-tax dollars, offering savers an upfront tax benefit. Once inside the retirement account, the money grows tax deferred. And then at retirement, withdrawals are taxed as ordinary income. By contrast, contributions to a Roth 401(k) are made with after-tax dollars, so there is no immediate tax benefit. However, at retirement, withdrawals come out tax free — provided you’re at least 59 1/2 and you’ve had the account for at least five years.

Because your daughter is in the 10% marginal tax bracket now, she pays very little taxes. Hence, the upfront tax benefit of the traditional 401(k) is worth less to her than someone in a higher bracket. “She is getting almost no benefit from the tax deduction of a 401(k),” says Coutu, who estimates that your daughter’s take-home pay will drop about $50 a month if she contributes 25% of her paycheck to a Roth 401(k) instead of a traditional 401(k).

In exchange for giving up a negligible amount of income today, your daughter stands to save a tremendous amount of money on taxes down the road. “Once that money is in a Roth, she doesn’t have to pay taxes on it ever again,” Coutu says. And remember that when she starts withdrawing money at retirement, she may be in a higher tax bracket.

“I say go for it,” Coutu adds.

What’s more, switching to a Roth 401(k) will not impact the amount that can be contributed to your daughter’s Roth IRA.

You can continue to fund the maximum — $5,500 a year for people under the age of 50 – as long as her total retirement savings does not exceed her gross earned income. At $13,000 a year, your daughter could save about 57% of her income in a Roth 401(k) before her total Roth savings would approach this limit.

As with a traditional 401(k), the contribution limit for a Roth 401(k) is 100% of income or $18,000 a year, whichever is less.

And if her employer makes matching contributions, so much that better.

That amount is not factored into the total, though employer matches would be put into a traditional 401(k).

You May Like