Leveraging Your Wealth

by Sherman Titens

It’s called a Roth 401(k) and, as its name suggests, it combines features of the traditional 401(k) with those of the Roth IRA. The Roth 401(k) concept was introduced with the Economic Growth and Tax Relief Reconciliation Act of 2001, which stipulated that employers could begin offering these plans on January 1, 2006.

Employers may offer the Roth 401(k) by adding it to an existing profit sharing or 401(k) plan, but, as with a Roth IRA, contributions will be made with after-tax dollars. While there is no upfront tax-deduction, the benefit is the account will grow tax-free and withdrawals taken during retirement will not be subject to income tax, as long as you are older than age 59∂ and the account has been held for five years or more.

The Roth 401(k) could be a boon for high-income individuals who haven’t been able to contribute to a Roth IRA because of income restrictions. (Roth IRA eligibility phases out between $99,000 and $114,000 for single filers and $156,000 to $166,000 for those who are married and file jointly.) There are no income stipulations for Roth 401(k)s.

In addition, Roth 401 (k) accounts are subject to the same contribution limits of regular 401(k)s—$15,500 for 2007 or $20,500 for those who are age 50 or older by the end of the year—allowing individuals to sock away thousands of dollars more in tax-free retirement savings than they would through a Roth IRA. (In 2007, Roth IRA contributions are limited to $4,000 a year or $5,000 for those who are age 50 or older.)

The hitch: Those limits apply to contributions to both types of 401(k) plans combined, so you can’t save $15,500 in a regular 401(k) and another $15,500 in a Roth 401(k).

Workers who are offered this new option 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.

If you expect your tax rate to be the same or higher in retirement than it is now, you might be better off with a Roth 401(k). This is likely to be the case with young people who are just starting their careers and expect their income to increase in the future. On the other hand, if you are in your peak earning years and expect your tax bracket to be lower in retirement, you will benefit from continuing to make contributions to a traditional 401(k).

In reality, of course, things are much more complicated. One reason people in top tax brackets have indicated a preference for the Roth 401(k) is no one can predict what tax rates will be in the future, although the general consensus is that they are likely to rise to help the government offset growing budget deficits and pay for Social Security and Medicare.

 

Bob Rippy, CFP®  is Senior Vice President and Branch Manager at the Kansas City office of Robert W. Baird & Co., member SIPC.
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