Is the Roth 401(k) Right for You?
The newest retirement savings vehicle isn't always the best option for middle-income employees
Every financial adviser will tell you to stash enough of your cash in a 401(k) retirement savings plan to get your employer's full match. But now workers face an additional choice. Should you park a portion of your salary in a traditional 401(k) and be freed from paying taxes on that portion of your income now? Or would it be better in the long run to invest in a Roth 401(k)? You pay taxes now, but you can take your money out tax free in your golden years. Here's a blueprint for deciding.
Find out if your company offers a Roth 401(k)—or might soon. Roth 401(k)'s were created by the Economic Growth and Tax Relief Reconciliation Act of 2001, which allowed companies to begin offering them on Jan. 1, 2006. About 12 percent of companies reported they already offer a Roth 401(k), according to a Hewitt Associates survey of employers done this year, and 32 percent were likely to add the feature at some point in 2007. So far, early adopters seem to like the new 401(k). Approximately 14 percent of participants in their 20s selected the Roth 401(k) option, and nearly a quarter of employees first enrolling in the 401(k) plan made theirs a Roth, Hewitt found. The average contribution rate was about the same as before the Roth option was available.
Get to know the basics. A Roth 401(k) is a cross between a Roth IRA and a traditional 401(k) plan. Like a Roth IRA, contributions are made with after-tax dollars, which will grow tax free. Withdrawals are tax free if taken at age 59½ or later from an account held for at least five years. As with a traditional 401(k), the Roth 401(k) is offered by employers that may or may not match a certain percentage of your contribution. However, only the employee contributions will be allotted to the Roth account. Any matching contributions are allocated to a pretax account, just as with traditional 401(k)'s.
A Tale of Two 401(k)'s
Here is a comparison of the main features of traditional and Roth 401(k) accounts.
| Traditional 401(k) | Roth 401(k) | |
| You invest | Pretax dollars | After-tax dollars |
| Account grows | Tax free | Tax free |
| Withdrawals | Taxed | Tax free if you're 59½ and have held the account for five years or more |
| Contribution limits | $15,500 in 2007 plus an additional $5,000 in catch-up contributions if age 50 or older | $15,500 in 2007 plus an additional $5,000 in catch-up contributions if age 50 or older |
| Employer match | Made with pretax dollars to accumulate in the same account | Made with pretax dollars to accumulate in a separate account and be taxed as income at withdrawal |
| When switching jobs | Roll over into an IRA | Roll over into a Roth IRA |
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.