Roth 401Ks On the Way!
Thanks to the Economic Growth and Tax Relief Reconciliation Act of 2001, employers will be able to offer Roth 401Ks to their employees starting January 1, 2006.
What exactly is a Roth 401K?
The Roth 401K combines the features of a 401k and a Roth IRA. Employers will offer it like a 401K plan but contributions will be made with after-tax dollars, just like a Roth IRA. Regular 401K contributions are made with pre-tax dollars, allowing for a substantial savings on your current year’s taxes. The Roth 401K will grow tax-free and at retirement, you will not need to pay income taxes on this money. Effectively, with a Roth 401K or Roth IRA, you are paying the income taxes up front at your current tax rate so you won’t have to pay them at retirement. With a standard 401K or Traditional IRA, you are receiving a tax break now and will be paying the taxes upon withdrawal.
Why would you want to contribute to a Roth 401K instead of a Roth IRA?
The Roth IRA has income restrictions. The amount you are allowed to contribute is reduced as you approach the income limits of $110,000 for single tax filers and $160,000 for married filers. 401Ks do not have income restrictions. Also, the Roth 401K has the same contribution limits as a normal 401K, which are much higher than a Roth IRA. For Roth and regular 401Ks, the total contribution limits for 2006 will be $15,000 ($20,000 for those 50+). Roth IRAs are capped at $4,000 a year ($5,000 for the 50+ crowd.)
Is it better to pay taxes on your retirement money at the time of contribution or at withdrawal? Morningstar.com has a good answer to this.
“One good reason is that taxes across the board may well be higher in the future than they are now (and I think that’s a pretty good bet, as the Economic Growth and Tax Relief Reconciliation Act [EGTRRA] of 2001 had some pretty generous provisions, many of which are set to expire in 2010). If that’s the case, you’re better off taking the tax hit now than you are later, when taxes are higher.
Moreover, your own profile could make the Roth 401(k) preferable to a traditional 401(k). If you expect to be in a higher tax bracket when you retire than you are right now, it’s obviously better to pay tax on that money at your current lower rate than it is to pay taxes when you’re in a higher income bracket in the future.
…The Roth 401(k) is apt to be appropriate for savers in many situations, but it’s not for everyone. In particular, employees who don’t expect to stash away a substantial sum for retirement (and unfortunately, many people fall into that category) will almost certainly be better off in a standard 401(k), as their income levels in retirement are apt to be lower than they were in their working years. And while your contributions to a conventional 401(k) reduce your taxable income on a dollar-for-dollar basis, that’s not the case for the Roth 401(k). That means that if you divert new contributions to a Roth, and thereby have a higher taxable income, you may no longer qualify for some credits and deductions that you were eligible for in the past.”
Things to keep in mind, many from Bankrate.com’s Roth 401K, a new way to grow money tax free:
Many financial planners are recommending you to hedge your bets and contribute to both a pre- and after-tax retirement account. No one can predict where tax rates will go or what your income will be in retirement, but the earlier you start investing in a Roth, the more tax-free interest you’ll earn by retirement. If you take advantage of it, your Roth retirement accounts will be a nice, tax-free bundle of joy waiting for you come age 59 1/2.
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October 3rd, 2005 at 2:59 pm
This article just appeared in today’s Boston Globe online.