More than simply a retirement plan, your 401(k) relies on its tax advantage to help you with your retirement. The concept is relatively straightforward. You put away money from each paycheck before taxes are taken from that total. This money is invested and the proceeds are taxed upon distribution. In the 2010 tax year, this contribution can be as much as $16,500 with an additional $5,500 allowed for investors over the age of 50. The “max” is still subject to your employer’s plan rules.
But perhaps you know something about your future. Perhaps you know now that when you retire, your tax bracket will be higher (or as high) as it is now. Do you use the available Roth 401(k) feature in your plan?
Tax rates are notoriously difficult to predict in advance of retirement. In all likelihood, they will be higher. If you expect to enter your retirement years without the tax deductions you enjoy now (mortgage, kids), a Roth 401(k) may be something worth considering. This type of plan might also be seen as beneficial even if the tax bracket you are in remains the same.
The hard part is not knowing. You can count on higher taxes in retirement for one simple reason. Taxes, at least all I have ever encountered, never seem to go down (one might be reduced only to be replaced by another going up and even if this seems like a benign trade-off, it usually means overall, your tax bill will creep up).
The other difficult thing to predict is what your retirement expenses will be. If you expect to be in pretty good financial shape when you reach retirement age or have the ability to continue working until the 401(k) trigger for distribution is hit (70 1/2 years old), your traditional 401(k) might not be the best investment plan to own. Generally, you are required to roll your assets from your 401(k) into some sort of IRA or annuity. This means that when that distribution requirement kicks in, you must begin withdrawing from those assets.
Here is where the Roth 401(k) differs. In a Roth 401(k), all of your investment dollars are made after taxes are paid. The same limits for contributions are usually imposed in a Roth 401(k) as they are in the traditional version of the plan and you can divided your contributions among the two plans. But upon retirement, the only taxes that haven’t been paid are on the growth of your investments less your contributions. So when the rollover event is trigger by retirement, the money rolls into a Roth IRA where there is no required distribution.
In 2010, Roth IRAs are limited to single taxpayers with $120,000 and married couples with $176,000 or less in adjusted gross income. But in a Roth 401(k) no such income threshold is in place making this plan making this plan doubly attractive for upper income wage earners looking to skirt the Roth IRA income limit rules.
There are some time-wise benefits as well. If your retirement horizon is very close, say five to ten years and you have been dutifully funding your 401(k), a Roth 401(k) might offer a certain appeal.
Keep in mind, the assets of one plan cannot be commingled with the other. For instance, if you already have a 401(k) and are considering opening a Roth 401(k), the contribution limits for the two plans are totaled – but, you cannot switch assets from one plan to the other. The same applies for your IRAs, both the traditional and the Roth.
When you rollover your assets from a 401(k), they cannot be rolled into a Roth IRA. They must go to a traditional IRA. When you rollover your Roth 401(k) it must go to a Roth IRA.
Many employers are not required to match Roth 401(k) contributions but are required to do so for the traditional 401(k) – if they match at all.
The bottom line: Roth 401(k)s are great tools for those making enormous amounts of income and are looking to protect those earnings from taxes in the future. For most of us, the traditional 401(k) will achieve our objectives just fine. You may, although use a Roth IRA for any additional investments if the investment horizon is expected to be short or you do not expect to need that money until much later in life.
Paul Petillo is the Managing Editor or Target2025.com
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