Home / Personal Finance / General / A Roth 401(k) offers tax advantages. Here’s how it works

A Roth 401(k) offers tax advantages. Here’s how it works

If you’re hesitant because you don’t want to lose the tax benefit of a traditional 401(k) contribution, consider this: Your savings strategies should be about more than short-term tax reduction.

People typically look at this decision as one of paying taxes now or paying taxes later. However, it is more complicated than that for most people. What it really comes down to is a look at cash flow today versus cash flow in retirement.

Taxpayers need to separate contributions from earnings. The standard 401(k) provides a current tax break, which means the actual savings cost less. The Roth 401(k) is an after-tax contribution so it reduces your current cash flow by the taxes you have to pay on these dollars.

The thing that many people forget is that the earnings are the most important part of this analysis. If the earnings are taxable as they are in a traditional 401(k), that can be a really high cost when distributions are taken over time, years in the future, with tax rates we can’t predict today.

If you opt for the Roth 401(k), the earnings are never taxed. Not ever.

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This is the best news and the biggest impact of Roth 401(k) plans. It is critical to really think about this: You may have earnings over 20 or 30 years and you will never pay taxes on these dollars.

That’s where the tax diversification comes in. Have a little bit of both kinds of accounts and you’ll have more planning possibilities when you need to withdraw money to support your retirement lifestyle.

The more options, the better.

If your employer doesn’t offer a Roth 401(k) yet, it’s time to call your benefits department to make the request. It’s not costly or complicated for the employer because they’re only amending an existing plan. And offering tax-free money to employees for retirement? That’s priceless.

Correction: This story has been updated to explain the required minimum distribution for a Roth 401(k) plan.

— By Diahann W. Lassus, a CNBC contributor and president of Lassus Wherley, a subsidiary of Peapack-Gladstone Bank

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About Virgie Powell

Virgie B. Powell writes for Reiterment Planning and Tax Advice sections in AmericaRichest.

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