Topics
Traditional and Roth
401(k)s
The Roth 401(k) may appeal to workers willing to forego a tax break now in return for getting one at retirement. As its name implies, the Roth 401(k) combines features of a traditional 401(k) with those of a Roth IRA.
Like a traditional 401(k), workers enjoy the convenience of contributing through payroll deductions. But similar to a Roth IRA, contributions are made on an after-tax basis and withdrawals after age 59 1/2 are tax-free and penalty-free for workers who have maintained their account for five years. There is also a Roth 403(b) plan for workers in the nonprofit sector.
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How a Roth 401(k) Works
The Roth 401(k) follows many of the same rules as a traditional 401(k). For the 2006 tax year, federal laws permit a maximum annual contribution of $15,000, although your employer may impose a lower limit. Your employer may provide a matching contribution as part of a Roth 401(k) offering, although you will be required to accept the matching contribution in a traditional, and not a Roth, account. If you are age 50 or older, you may contribute an additional $5,000 for a total of $20,000 in 2006.
You may continue to maintain a traditional 401(k) while directing all or a portion of new contributions to a Roth 401(k). Your contributions to a Roth 401(k), however, are irrevocable â once made, they cannot be transferred to a traditional 401(k) account and funds in a traditional 401(k) cannot be switched to a Roth 401(k). Both Roth and traditional 401(k)s require distributions after age 70 1/2.
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Planning for Retirement
A Roth 401(k) may present a significant benefit when it's time for retirement â the funds can be rolled over directly to a Roth IRA with no tax payment, a feature that is currently not available with a traditional 401(k) account. A traditional 401(k) must first be rolled over to a traditional IRA and the traditional IRA then converted to a Roth IRA, although such conversions will be possible beginning in 2008. A Roth IRA conversion requires you to pay taxes on the portion of the rollover that has not yet been taxed.
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Roth vs. Traditional 401(k)s: A Quick Comparison
The table below presents a summary of the most important differences between Roth and Traditional 401(k)s.
| Traditional 401(k) |
Roth 401(k) | |
| Tax Status of Contributions | Pretax contributions reduce current taxable income. | After-tax contributions do not affect current taxable income. |
| Tax Status of Distributions After Age 59 1/2 | Taxed as current income. | Tax free and penalty free for investors who have had the account for at least five years. |
| Rollovers to IRAs | Must currently be rolled over first to a traditional IRA, then converted to a Roth IRA, which requires a tax payment. | May be rolled over directly to a Roth IRA with no tax payment. |
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To Roth or Not to Roth?
If you're considering a Roth 401(k), you may want to review the following points before making your decision:
- Although future tax rates are difficult to predict, you may benefit from a Roth 401(k) or 403(b) if you anticipate being in a higher tax bracket during retirement.
- Even if your marginal tax rate remains relatively stable, you may face a higher tax bill in retirement if you no longer claim deductions for dependents and mortgage interest, as well as other deductions frequently utilized by families. If this sounds like a likely scenario, a Roth 401(k) may be to your advantage.
- Will you need your retirement assets for living expenses during your later years? If not, a Roth 401(k) offers the opportunity to roll over funds directly to a Roth IRA, which does not require distributions after age 70 1/2. This situation may enhance the potential tax-free growth of your assets and enable you to bequeath a larger portion of your assets to your heirs.
- You are not required to meet income thresholds to participate in a Roth 401(k). Roth IRAs are limited to single taxpayers with $110,000 and married couples with $160,000 or less in adjusted gross income. A Roth 401(k) may have some appeal if you desire tax-free withdrawals but your income exceeds the threshold for a Roth IRA.
- The longer you remain invested in a Roth 401(k), the more you are likely to benefit from tax-free growth. If you plan to retire in five years or less, a shorter-term time horizon may limit the benefit of tax-free withdrawals, whereas your account may get a bigger boost from tax-free savings if you plan to continue working for a longer period of time.
Capitalizing on every option available to you may make it easier to pursue your long-term savings goal. If tax-free withdrawals could potentially benefit you, and your employer makes a Roth 401(k) available, consider adding it to your retirement planning mix.
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Summary
- A Roth 401(k) offers the option of investing for retirement on an after-tax basis. In return for foregoing a tax deduction when the contribution is made, participants are able to make withdrawals free of penalties and income taxes during retirement.
- Workers may elect to make all or a portion of their 401(k) contribution to a Roth 401(k). Once made, however, a contribution cannot be transferred to a traditional 401(k) and assets in a traditional 401(k) cannot be switched to a Roth 401(k).
- The annual maximum contribution for 2006 is the same as for a traditional 401(k): $15,000 plus an additional $5,000 catch-up contribution for employees aged 50 and older.
- Employers who provide a matching contribution are required to allocate the match to a traditional 401(k), not a Roth account.
Checklist
- Calculate a retirement savings goal and figure out how much you'll need to accumulate between now and the time you retire.
- Decide which type of 401(k) is more appropriate for pursuing your goal.
- Choose an asset allocation (investment mix) for your account that addresses your unique financial goal, time frame, and risk tolerance.
- Plan to increase 401(k) contributions whenever possible, such as after receiving a raise.
