By Jason Alderman
Ever since Individual Retirement Accounts were introduced in the 1970s, the numbers of tax-advantaged retirement savings options – and participants – have continued to grow. One relatively new alternative that’s gaining popularity is the Roth 401(k) plan.
401(k)s are retirement savings plans set up by employers that allow employees to save for their retirement through automatic payroll deductions. As its name suggests, the Roth 401(k) combines features of a traditional 401(k) with those of a Roth IRA. Employers increasingly have begun offering Roth alternatives, so it’s wise to understand how they work in case you are given the option.
In a traditional 401(k) plan, employee contributions are usually made on a pretax basis; that is, deducted from your pay before federal and state income taxes are calculated. This lowers your taxable income and therefore, your taxes. You don’t pay taxes on these savings or their investment earnings until they’re withdrawn – usually after retirement.
With a Roth 401(k) you contribute after-tax dollars. Although you don’t get an upfront tax break, your account grows tax-free and withdrawals aren’t later taxed, provided you’ve had the account at least five years and are age 59 ½ or older – or have become disabled or die.
A few things to remember:
- The combined 2010 annual limit for employee 401(k) contributions – whether regular and/or Roth – is $16,500 ($22,000 if over 50).
- Roth 401(k) contributions cannot later be converted moved into a regular 401(k), or vice versa.
- Before age 59 ½, all 401(k) withdrawals, whether Roth or regular, may be subject to a 10 percent early withdrawal penalty on the taxable amount. Exceptions may be made for death or disability, catastrophic medical expenses, first-time homebuyer loans and being 55 or older at retirement or job termination. See IRS Publication 575 for details (www.irs.gov).
With either type of 401(k), you must begin taking mandatory minimum distributions from your account after you turn 70 ½, just as you must with a regular IRA. However, you can avoid mandatory withdrawals by converting your Roth 401(k) into a Roth IRA, which has no such requirement. You can also convert a pretax 401(k) into a regular IRA and then into a Roth IRA; but you must pay tax on the converted amount, just as you would with any regular 401(k) withdrawal.
Many people wrestle between Roth and regular 401(k) contributions. A few considerations:
- Will your tax rate be higher now or at retirement? Those in their peak earning years may have a higher marginal tax rate currently than at retirement, whereas those just beginning their careers may see their rates rise over time.
- Many financial experts think future income tax rates will likely climb due to federal budget deficits and increasing demands on Social Security and Medicare.
- The longer you remain invested in a Roth 401(k), the more likely you are to benefit from tax-free account growth.
- Consider where you’ll retire, as many states have low or non-existent income tax.
When it’s not clear which type of 401(k) – or IRA – is best for their particular situation, some people diversify their retirement savings by contributing to both a Roth and a regular 401(k).
Jason Alderman directs Visa’s financial education programs. To Follow Jason Alderman on Twitter: www.twitter.com/PracticalMoney
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