Roth 401(k): Your Questions Answered

Summary

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WSJ Your Money Briefing

Episode: Roth 401(k): Your Questions Answered
Date: June 3, 2019
Host: J.R. Whalen
Guest: Laura Saunders, WSJ Tax Reporter

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Episode Overview

This episode responds to a flood of reader and listener questions about Roth 401(k)s and how they compare to traditional 401(k)s and IRAs. Host J.R. Whalen brings back WSJ tax reporter Laura Saunders to clarify the similarities and differences among these retirement accounts, explain the role taxes play, and discuss how features like penalty-free withdrawals work—especially in emergencies. The episode is designed to give listeners actionable personal finance tips as they plan for retirement and navigate workplace benefits.

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Key Discussion Points & Insights

1. Similarities Among Tax-Favored Retirement Accounts

• Tax-Free Growth:
  All tax-advantaged retirement accounts (Roth and traditional, 401(k) and IRA alike) allow money to grow and compound tax-free while invested.

  • Quote:
    “All these tax favored retirement accounts…let your money compound and grow tax free. The whole time it’s in the account, it grows tax free.” – Laura Saunders (02:13)

• Contrast with Brokerage Accounts:
  In regular brokerage accounts, dividends and profits are immediately taxable, whereas in retirement accounts, those pay-outs are sheltered from current-year taxes.

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2. Key Differences: 401(k) vs. IRA, and Roth vs. Traditional

• 401(k) vs. IRA:

  • 401(k) = Employer-sponsored workplace retirement plan; may include employer match.
  • IRA = Individual Retirement Account; set up independently by the individual.
  • Quote:
    "One is offered by your employer...the other one you can have on your own." – Laura Saunders (02:53)

• Roth vs. Traditional (Tax Treatment):

  • Traditional:
    • Get a tax deduction now, pay taxes when you withdraw in retirement.
    • Deferred taxation strategy.
  • Roth:
    • Pay taxes now, tax-free withdrawals in the future.
    • Growth and withdrawals often completely tax-free.
  • Quote:
    “Traditional accounts…give you a tax deduction going in...Roth accounts...you pay taxes on the money going in, but the growth is tax free. And then all the withdrawals can be tax free.” – Laura Saunders (03:34)

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3. How to Choose: The Role of Tax Brackets & Location

• Tax Bracket Considerations:

  • The central question: Is your tax rate likely to be higher now or in retirement?
    • Younger workers with currently low incomes may generally benefit from Roth accounts, expecting higher tax brackets later.
    • Near-retirees moving to low-tax states may prefer traditional accounts.
  • Quote:
    “If you have a choice…do I go Roth or traditional? Then you've got to look very hard at what you think your tax rate is now versus coming out.” – Laura Saunders (04:21)

• Geographical Tax Factors:

  • Consider both current and anticipated future state and local taxes when making decisions about contributions or conversions.
  • Quote:
    “Tax rate in state and local and federal versus tax rate out state and federal.” – Laura Saunders (05:11)

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4. Roth IRA Flexibility for Emergencies

• Penalty-Free Withdrawals of Contributions:
  • With Roth IRAs (not Roth 401(k)s), you can always withdraw your own contributions, penalty- and tax-free, at any time.
  • Makes the Roth IRA useful as a backup emergency fund or as a savings strategy for large short-term goals.
  • There are annual contribution limits and income qualifications.
  • Quote:
    “Roth IRAs have the most flexibility...if you put money into a Roth IRA...you can always take out the contributions without paying any taxes or penalties. This makes a Roth IRA a really good savings account for...younger workers.” – Laura Saunders (05:30)
  • Note: You must maintain clear records to track contributions versus earnings, as only contributions can be withdrawn freely.

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5. Workplace Roth 401(k)s: Know Your Options

• Roth 401(k) Availability:
  • Not all employers offer Roth 401(k)s; employees should check with their HR departments.
  • Workers can split contributions between traditional and Roth 401(k), optimizing for their likely tax situations.
  • Always maximize employer match when available (“free money”).
  • Quote:
    “It can be a very good thing for younger workers to split...part to a 401, part to a Roth 401. Of course, you always want to get the employer match. That's free money and you don’t want to leave it on the table.” – Laura Saunders (06:51)

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Notable Quotes & Memorable Moments

• On the importance of understanding retirement accounts:
  “This is a time when people have to do more to save for their own retirement because we don’t have company pensions anymore.” – Laura Saunders (02:13)

• On using Roth IRAs as a savings vehicle:
  “A Roth IRA...can always turn to your Roth IRA and pull out the contributions. Not the earnings, but the contributions. So you need records, but the contributions can come out and they’re there in a pinch. And that’s a good thing to know.” – Laura Saunders (05:30)

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Important Timestamps

• [02:13] – Similarities among retirement accounts: tax-free compounding
• [03:34] – Roth vs. traditional: How taxes apply going in and coming out
• [04:21] – Deciding between Roth and traditional based on expected tax bracket
• [05:30] – Roth IRA’s flexibility for emergencies and early withdrawals
• [06:51] – Roth 401(k) availability and splitting contributions; always maximize the employer match

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Takeaways for Listeners

• All retirement accounts allow for tax-free growth, but the timing of taxes (now versus later) is a critical distinction.
• Choosing between Roth and traditional should be informed by your current and expected future tax brackets, as well as your living location.
• Roth IRAs offer unique flexibility for those who may need access to their funds in an emergency, without tax or penalty on contributions.
• Employer-offered Roth 401(k)s can be an excellent option, especially when paired with traditional plans and employer matching.
• Good record-keeping is essential for tracking Roth IRA contributions vs. earnings.

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For more details, Laura Saunders’ written guide is available at WSJ.com and via the WSJ app.

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Transcript

[Deel Representative]

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[J.R. Whalen]

Here's your Money briefing. I'm J.R. whalen at the Wall Street Journal in New York. We explained Roth 401s and traditional 401s a few weeks ago, and boy do we get a lot of letters and emails asking us to go into more detail. Well, Journal tax reporter Laura Saunders will be here in a moment to tackle some of your questions. First, these money and market stories that you should know. The Commerce department says the U.S. household spending rose 0.3% in April. That's a little slower than the previous month, but it's still considered a solid pace. Income growth is one factor driving that spending. Americans pre tax earnings from wages, salaries and investments advanced 0.5% income in April from the prior month. That was the best gain this year. And one of the pieces of data to come out of Uber's earnings report was the fact that the company sees its price war with competitor Lyft settling down. Uber reported about a billion dollars in losses for the first quarter, but the company's CEO says that competition will be more centered on brand and products going forward, rather than incentives for customers. And Lyft executives essentially said the same thing on a conference call with investors and reporters. And by the way, Uber said in the first quarter about 77% of revenue came from ride hailing, while 17% came from Uber Eats. Earlier in May, tax reporter Laura Saunders was here to compare and contrast traditional 401s and Roth 401s along with how they differ from IRAs. And then the email floodgates opened up. Journal readers and listeners had lots of questions and Laura is back to answer some of them. So Laura, of course, IRAs and 401s, whether they're traditional or in the Roth category, they differ. But many asked you how they're alike and there are a few ways that they line up.

[Laura Saunders]

Yes, there absolutely are. This is a time when people have to do more to save for their own retirement because we don't have company pensions anymore. So people need to understand these details. And what all of these tax favored retirement accounts have in common is that they let your money compound and grow tax free. The whole time it's in the account, it grows tax free. Now if you just had a stock in a brokerage account and it paid you a dividend, that would be taxable. But inside of one of these accounts that Growth is tax free. The dividends, the trading profits, everything else, it's tax free.

[J.R. Whalen]

And just to catch everybody up, how are they different?

[Laura Saunders]

Well, that's a much bigger question. There are lots and lots of differences. And so if you want to know all about them, read the story. But there are two big, I guess two big differences. One is that anything that says 401 is a workplace retirement plan, pretty much it's offered by an employer. And anything that says IRA is pretty much an individual plan. Now they're both managed by you, like you put in the money, you make investments and things like that. But one is offered by your employer. Sometimes your employer matches a 401k contribution, but the other one you can have on your own.

[J.R. Whalen]

So in your story you talk about roth accounts. Both IRA and 401 have some key benefits.

[Laura Saunders]

Yes, they do. We first talked about workplace versus non workplace plans. Now let's look at the difference between Roth accounts versus traditional accounts. Traditional accounts, IRAs and 401s, they give you a tax deduction going in. You don't pay any taxes up front. You pay taxes after they grow for years and years and years and years. When the money comes out, that's when you pay your taxes. Roth accounts, either IRAs or 401s are the opposite. You pay taxes on the money going in, but the growth is tax free. And then all the withdrawals can be tax free.

[J.R. Whalen]

So the strongest variable here is the tax bracket that you're in based on your income, not necessarily how long you invest.

[Laura Saunders]

Yes. If you have a choice, do I go Roth or traditional? Then you've got to look very hard at what you think your tax rate is now versus coming out. If you're a 25 year old who is just starting to work, you can probably bet that your tax rate is going to be higher later on. And so maybe a Roth is a good way to go. Now you'll get all that tax free compounding and it'll come out tax free. And then if you're just retired, say, and you know that you're moving to a low tax state, then I wouldn't put money in Roth accounts or convert or anything like that because you're going to move to a place where the taxes are lower. So you don't want to pay taxes at a higher rate now.

[J.R. Whalen]

So pay attention to what your income is and how that might move you into a different bracket, but also the taxation based on where you're living.

[Laura Saunders]

Yeah, tax. Yes, tax rate in state and local and federal versus tax rate out state and federal.

[J.R. Whalen]

All right. Now, most people put money away in retirement accounts until, well, they retire. But a lot of readers asked you specifically about how a Roth IRA can be used in case of emergency.

[Laura Saunders]

Well, this is a vast topic. Can you get money in these accounts before Uncle Sam really wants you to, you know, when you're not retired? And I'm going to write another story about that at some point. But my big tip here is that Roth IRAs have the most flexibility if you qualify for them by income because there are some income limits. But if you put money into a Roth IRA, not talking 401, Roth 401, but a Roth IRA, you can always take out the contributions without paying any taxes or penalties. This makes a Roth IRA a really good savings account for a, say, younger worker who you could put your emergency savings into it, you know, 6007, $6,000 a year US or if you're trying to save up to buy a house, you could do that. And then if you need to get a little extra money for that down payment or if you have some emergency, you can always turn to your Roth IRA and pull out the contributions. Not the earnings, but the contributions. So you need records, but the contributions can come out and they're there in a pinch. And that's a good thing to know.

[J.R. Whalen]

And with regard to the Roth 401K, that's somewhat new on the investment stage and it's a good idea to check with your company you work for to see if they offer it.

[Laura Saunders]

Yes, yes, it really is because it can be a very good thing for younger workers to split. You can split your contributions part to a 401, part to a Roth 401. Of course, you always want to get the employer match. That's free money and you don't want to leave it on the table. The story says some things about that too. But Roth 401 is a good thing to opt into for many people who for part of what their savings are.

[J.R. Whalen]

All right, that's Laura Saunders. Check out her story on WSJ.com or the WSJ app and she's good enough to be here in our studio. Laura, thanks for coming on the show

[Laura Saunders]

and thanks for having me.

[J.R. Whalen]

And that's your money briefing. I'm JR Whalen in New York for the Wall Street Journal.

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