Is the Roth 401(k) Right for You?
The newest retirement savings vehicle isn't always the best option for middle-income employees
Familiarize yourself with the limits. Unlike Roth IRAs, which have income limits (eligibility phases out between $99,000 and $114,000 in modified adjusted gross income for single filers and between $156,000 and $166,000 for joint filers in 2007), Roth 401(k) contributions can be made by employees with any level of income. That allows affluent savers to stash away thousands of dollars to accumulate tax free that they otherwise wouldn't be able to.
But there are limits on how much an individual can invest. You can make contributions to both a Roth 401(k) and a traditional 401(k) in the same year in any proportion you choose. However, the combined amount contributed to one or more 401(k) funds in a single year is limited to $15,500 in 2007, plus an additional $5,000 in catch-up contributions for those 50 or older. Investing a little in each type of 401(k) may allow you to hedge your bets against future tax increases.
Check out your tax rate. To decide which 401(k) is better for you, weigh your current tax rate against what you estimate your tax rate will be in the future. If your tax rate is currently higher than you think it will be in retirement, you'll want to delay taxation by choosing a traditional 401(k). But if you expect your tax rate to be higher in retirement, it's better to incur tax immediately and save in a Roth 401(k).
"A Roth 401(k) would definitely be to the advantage of a younger person because they're probably only paying 15 percent to 25 percent in taxes," and their savings have many years to accumulate, says Cynthia Conger, a wealth manager in Little Rock, Ark. But for someone who is older, "they're going to be in a higher tax bracket now," Conger says. "For someone who is around age 45, that's when getting the lower taxable income that year is going to be a better thing."
Two-income families may want to carefully weigh their options as well. "If both mom and dad are working, you do reach a point where taxes become an issue," says Elizabeth Rutter Baer, a certified financial planner in Lansing, Mich. "For many clients, it's a greater benefit to them to get the tax benefit now" by contributing to a traditional 401(k) with pretax dollars.
People in the middle-income range, who make between $25,000 and $75,000 annually, should also think very carefully before choosing the Roth. "A lot of those folks are going to be in lower-income tax brackets when they retire and get half of their income from Social Security and half from the plan," says David Wray, president of the Profit Sharing/401(k) Council of America. "They should continue to use the deferred approach."
Some 40 percent of Americans 55 or older report having less than $50,000 worth of savings and investments, according to the Employee Benefit Research Institute. And EBRI estimates that the average monthly Social Security benefit in 2007 is $1,044 for single workers and $1,713 for couples with both people receiving benefits—or $20,556 a year per couple. That means many workers will be in a lower-income tax bracket in retirement than they were in during their peak earning years. So, in this case, assuming income tax rates don't rise sharply, it might be better to take the tax break while you're working by using the traditional 401(k).
Plan for passing it on. If you plan to bequeath money to children or relatives, there are additional factors to consider. With a traditional 401(k), the heir must pay taxes as he or she withdraws the money. If your employer's 401(k) plan doesn't make it easy for your heir to space out the tax payments, you might want to roll over the money into an IRA, generally after you leave the company.
However, an heir may be able to receive tax-free distributions of the money left through a Roth 401(k) if the account is at least five years old. "If you are willing to pay the taxes now to create tax-free income later, it's a better deal for them because they don't have to pay income tax for their inheritance," says David Phillips, CEO of Estate Planning Specialists. Alternatively, the money could be rolled over into a Roth account held by the surviving spouse or an alternate payee. But either type of 401(k) may still be subject to estate taxes.
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