Is the Roth 401(k) Right for You? Think About Taxes
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: Park part of your salary in a traditional 401(k) and be freed from paying taxes on that income now? Or 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 earlier this year, and 32 percent were likely to add the feature at some point in 2007.
—Learn the basics. A Roth 401(k) is a cross between a Roth IRA and a traditional 401(k) plan. Like those to a Roth IRA, contributions are made with after-tax dollars, which will grow tax free. Withdrawals are tax free if taken at age 59
—Know your limits. Any employee, regardless of income level, can make Roth 401(k) contributions. That allows affluent savers to stow away thousands of dollars to accumulate tax free that they otherwise wouldn't be able to. And you can put money in both a Roth 401(k) and a traditional 401(k) in the same year in any proportion you choose. But for 2007, the combined amount contributed to one or more 401(k) funds can't top $15,500, plus $5,000 in catch-up contributions for those 50 or older. Investing a little in each type of 401(k) should let you hedge your bets against future tax increases.
—Think about taxes. Weigh your current tax rate against what you estimate you'll pay in the future. If your tax rate is higher now than you expect it to be in retirement, delay taxation by choosing a traditional 401(k). But if you think your tax rate will be higher in retirement, it's better to incur tax immediately and save in a Roth 401(k). Younger taxpayers with lower incomes generally will benefit from using a Roth 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. In effect, you can pay taxes now to create tax-free income for your heirs later. Or the money could be rolled over into a Roth IRA held by the surviving spouse or an alternate payee. But either type of 401(k) may still be subject to estate taxes.
This story appears in the September 10, 2007 print edition of U.S. News & World Report.