Ever since Individual Retirement Accounts were introduced in the 1970s, the numbers of tax-advantaged retirement savings options -- and participants -- have continued to grow. One relatively new alternative that's gaining popularity is the Roth 401(k) plan.
401(k)s are retirement savings plans set up by employers that allow employees to save for retirement through automatic payroll deductions. As its name suggests, the Roth 401(k) combines features of a traditional 401(k) with those of a Roth IRA. Employers increasingly have begun offering Roth alternatives, so it's wise to understand how they work in case you are given the option.
Pretax Vs. After-tax Contributions. In a traditional 401(k) plan, employee contributions are usually made on a pretax basis; that is, deducted from your pay before federal and state income taxes are calculated. This lowers your taxable income and therefore, your taxes. You don't pay taxes on these savings or their investment earnings until they're withdrawn -- usually after retirement.
With a Roth 401(k) you contribute after-tax dollars. Although you don't get an upfront tax break, your account grows tax-free and withdrawals aren't later taxed, provided you've had the account at least five years and are age 59 1/2 or older -- or have become disabled or die.
A few things to remember:
- The combined 2010 annual limit for employee 401(k) contributions -- whether regular and/or Roth - is $16,500 ($22,000 if you are over 50-years-old).
- Roth 401(k) contributions cannot later be moved into a regular 401(k) account.
- Before age 59 1/2, all 401(k) withdrawals, whether Roth or regular, may be subject to a 10 percent early withdrawal penalty on the taxable amount. Exceptions may be made for death or disability, catastrophic medical expenses, first-time homebuyer loans and being 55 or older at retirement or job termination. See IRS Publication 575 for details.
Many people wrestle between Roth and regular 401(k) contributions. A few considerations:
- Will your tax rate be higher now or at retirement? Those in their peak earning years may have a higher marginal tax rate currently than at retirement, whereas those just beginning their careers may see their rates rise over time.
- Many financial experts think future income tax rates will likely climb due to federal budget deficits and increasing demands on Social Security and Medicare.
- When estimating future taxable earnings, don't forget pension payments, part-time income and investment earnings. These, combined with taxable income from regular 401(k) withdrawals, could conceivably boost you into a higher tax bracket.
- The longer you remain invested in a Roth 401(k), the more likely you are to benefit from tax-free account growth; so if you plan to retire in 10 years or less, that may not be enough time to reap sufficient benefit from paying your taxes upfront.
- Consider where you'll retire, as many states have low or non-existent income tax. (The Retirement Living Information Center features breakdowns of the various kinds of taxes seniors are likely to pay, state by state, including taxes on income, sales, fuel, property, inheritances and other items.)
Conversely, by contributing to a Roth versus a regular 401(k), you will increase your taxable income, which could impact your eligibility for tax benefits that are phased out at certain income limits, or it could even push you into a higher tax bracket.
Personally, I am a big fan of all things Roth. I'm 40 years old and the bulk of my own retirement savings are in Roth accounts.
When it's not clear which type of 401(k) -- or IRA -- is best for their particular situation, some people diversify their retirement savings by contributing to both a Roth and a regular 401(k). A good tax or financial advisor can help you determine which method is best for you. If you don't already have a financial advisor, the Financial Planning Association can help you locate one in your area.
This article is intended to provide general information and should not be considered tax or financial advice. It's always a good idea to consult a tax or financial advisor for specific information on how tax laws apply to you and about your individual financial situation.
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