The 401(k) Gets a Makeover for 2006
I t took 25 years, but Uncle Sam has come out with Version 2.0 of the 401(k). Like the traditional 401(k), the Roth 401(k) is a tax-advantaged retirement plan that lets workers save through automatic salary deferrals. But the new Roth flips the concept of the 401(k) on its head. In a traditional 401(k), workers fund their accounts with pretax dollars; the money grows tax deferred; and withdrawals at retirement are taxed as ordinary income.
But a Roth 401(k) is more like a Roth IRA (hence the moniker). The worker puts after-tax dollars in these tax-sheltered plans. And at withdrawal, money comes out tax free.
Even though companies only began offering Roth 401(k)'s on January 1, most workers at small-to-medium-sized firms have already heard of the accounts, according to the Principal Financial Well-Being Index. But the vast majority of companies don't yet offer these plans. A recent survey by Hewitt Associates found that only 6 percent of firms that currently offer traditional 401(k)'s are "very likely"to start a Roth option this year, though nearly a third are considering it.
If your employer makes available a Roth 401(k), should you take advantage of it? Lori Lucas, director of retirement plan participant research at Hewitt, says the answer will depend largely on your response to two key questions: What tax bracket are you in today, and what tax bracket do you expect to be in at retirement? "If you're early in your career, making a fairly modest salary, but anticipate being in a higher tax bracket in retirement, that's a scenario that makes the Roth 401(k) appealing," says Lucas.
But for workers in their 40s and 50s, the choice isn't so simple. That's because a baby boomer in his 50s who funds a Roth might be paying taxes up front when he's in a high bracket--only to withdraw the money when he's in a lower bracket.
T. Rowe Price crunched the numbers and found out how murky the choice really is. The mutual fund giant took the hypothetical case of a 55-year-old who socks away $15,000 a year (minus income taxes) in a Roth 401(k) until retirement at age 65. This example assumes the worker is currently in the 25 percent federal tax bracket and keeps the bulk of his money in the 401(k) throughout a 30-year retirement.
By the time this worker turns 95, he will have generated $412,582 in total income through the Roth. Would he have been better off in a traditional 401(k)? It all depends on the income tax bracket he's in at retirement. If this same worker puts $15,000 a year in a traditional 401(k) and retires in the 15 percent bracket, he will be able to generate $467,592 in retirement income after taxes. That's better than the Roth. But if he retires in the 28 percent bracket, the traditional 401(k) will produce only $396,078 in after-tax income--which is worse than the Roth.
Wrinkle.Older workers may find traditional 401(k)'s useful for other reasons. By contributing to a traditional 401(k), you can lower your adjusted gross income, which in turn can qualify you for other tax breaks. Here's one more wrinkle: If your company matches your Roth 401(k) contributions, that money will have to be kept in a separate account. Uncle Sam still wants to tax money obtained from company matches, as well as investment gains earned on that money.
So a simple solution may be taking full advantage of a traditional 401(k) up to the company match. Then you could use your remaining savings to fund the Roth. The Roth 401(k) "dovetails with the regular 401(k)," says Mike Scarborough, president of investment advisers the Scarborough Group. This is why Scarborough says "people need to start asking their employers to install the Roth 401(k)--now."
When A Foreign Accent Helps
Last year was marked by two trends: the emergence of foreign stock funds and the re-emergence of growth funds as market leaders. The biggest winners among the nation's 25 largest funds (right) included American Funds EuroPacific Growth, which invests mostly in Europe and Asia; Fidelity Diversified International, which has a worldwide focus; and Fidelity Contrafund, which buys shares of large-capitalization U.S. companies. International stock funds posted nearly double the returns of domestic equity portfolios, gaining around 18 percent on average. Among U.S. stock funds, small-cap, mid-cap, and large-cap funds that invest in growth stocks beat their value-oriented competitors. Based on a recent survey of money manager sentiment, investors can expect more of the same in 2006.
This story appears in the January 16, 2006 print edition of U.S. News & World Report.