Personal Finance: New retirement wrinkle: Roth 401(k)
It's been four years since the Bush administration won passage of the Economic Growth and Tax Relief Reconciliation Act of 2001, which slashed income-tax rates across the board, eradicated the marriage penalty and put the so-called death tax on the road to eventual elimination. But what many taxpayers forget is that embedded within this legislation is another provision that gives birth, on Jan. 1, 2006, to a new type of employer-sponsored retirement account: the Roth 401(k).
Like a regular 401(k), a Roth 401(k) will allow workers to invest money in a collection of mutual funds tax-deferred throughout their careers. But unlike a traditional 401(k), contributions into these new accounts will be made with after-tax dollars. Moreover, withdrawals at retirement will be completely tax free, just as they are with a Roth IRA.
Before you get too excited about these plans, keep in mind that there are a few wrinkles. For starters, while the Bush tax cuts of 2001 gave birth to the concept of the Roth 401(k), there's no requirement that your employer offer such a plan. So if you want access to a Roth 401(k), now is the time to lobby your human resources department.
Some companies are already planning to offer the new accounts. According to a recent survey by the employee benefits consulting firm Hewitt Associates, 31 percent of employers who currently offer traditional 401(k)'s say that they're likely to add the Roth 401(k) come January.
Others are taking a wait-and-see attitude. Some plan sponsors fear that with so many different types of retirement accounts in existence, a Roth 401(k) "may add to the overall level of complexity in retirement savings, which could in fact impede people from taking full advantage of these plans," says Lori Lucas, Hewitt's director of retirement plan participant research.
So are these plans a good deal? In general, yes. But you have to keep several things in mind:
- Traditional 401(k)'s are still a great deal. While some may jump at the chance to invest, say, $15,000 annually in a Roth 401(k), keep in mind that it will cost you the full $15,000 to shove that amount into that account. That's because you're using after-tax dollars to contribute to these plans. By contrast, since traditional 401(k)'s are funded with pre-tax dollars, it may cost you only $11,000 to $12,000 to put $15,000 into your account.
- Roth 401(k)'s may be most appropriate for workers who expect to be in a high tax bracket when they retire, says Hewitt's Lucas. That's because the tax benefit (the fact that you can withdraw money from these accounts tax free) is worth more if you're in a high bracket.
- Roth 401(k)'s will also make sense for young workers. That's because they have the longest time horizons. The additional years of tax-deferred investing can help them make up the difference for having to pay taxes on contributions upfront. Moreover, young workers tend to earn the least, which means paying income taxes upfront isn't as big a burden on them as on higher-paid older employees.
- While the Roth 401(k) represents a different type of retirement account from a traditional 401(k) plan, the government still plans to limit total 401(k) contributions to $15,000 in 2006 ($20,000 if you're 50 or older). In other words, money that flows into a Roth 401(k) may have to be diverted from your regular 401(k).