Beginning January 1, 2006 employers have the opportunity to offer a new 401(k) option aimed at decreasing your tax burden during your retirement years. Starting in 2006, 401(k) plans will be permitted to allow employees to designate their contributions as 'Roth' contributions.
If offered, your decision whether or not to contribute to the new option ' known as a Roth 401(k) ' will require the same considerations as to whether or not to contribute to a regular IRA or a Roth IRA (with the exception that the Roth 401(k) has fewer limitations and larger contribution limits). Currently, more than 30% of surveyed employers said they were very or somewhat likely to offer a Roth 401(k) in the year 2006, according to data from the consulting firm Hewitt Associates Inc.
The Roth 401(k) could be a boom for high-income individuals who haven't been able to contribute to a Roth IRA because of the income restrictions. (Eligibility phases out between $95,000 and $110,000 for single filers and $150,000 to $160,000 for those who are married and file jointly). There are no income stipulations for Roth 401(k)s.
The Roth 401(k) combines elements of the traditional 401(k) with the tax benefits of the Roth IRA. It allows you to contribute with after-tax dollars to a tax-deferred savings account in exchange for the benefit of withdrawing that money tax-free in retirement. The traditional 401(k) is funded with pre-tax dollars and withdrawals are taxed as income.
Workers with access to both a Roth 401(k) and a traditional 401(k) will be limited to the same contribution cap as people with just one 401(k): a maximum of $15,000 for 2006, or $20,000 for people age 50 and over by the end of the year. This leaves workers with three choices: they can continue to contribute solely to the traditional 401(k); they can divert their contributions to the Roth 401(k); or they can split their contributions between the two types of accounts.
For workers to gauge whether the benefit of tax-free withdrawals down the road is worth the upfront cost, they will have to predict their personal tax situation during retirement. As a general rule, the Roth is a good solution for people who expect to be at the same or higher tax bracket in retirement.
However, workers who are offered this new option this year face a difficult choice: contribute to a Roth 401(k) and suffer a cut in take-home pay (since contributions are made with after-tax dollars), or stick with a traditional 401(k) and hope that in retirement, their tax rate will be lower than it is now. Alternatively, they could hedge their bets by contributing to both accounts.
The big hidden benefit is the fact that investors will be able to roll over the Roth 401(k) into a Roth IRA and avoid required minimum withdrawals at age 70 1/2. One nasty but often-ignored fact about 401(k)-type plans and conventional IRAs is that the government requires that you pull out money from these vehicles, regardless of whether or not you need the money.
Simply put, the more and longer you keep your money in Roth accounts, the more it can compound tax-free. With more people living 20 years to 30 years past retirement age, this is a great way to build and preserve wealth.