Recs

6

The ABCs of the Roth 401(k)

Do you want a break now, or would you like it later?

That's the question investors have had to ask themselves when making the choice between a traditional IRA and a Roth IRA. A contribution to a traditional IRA could mean a tax deduction this year (assuming you're eligible), plus the investments grow tax-deferred. However, when money is taken out in retirement, the withdrawals are taxed as ordinary income.

The Roth IRA, however, permits investors to forgo a tax deduction now in exchange for tax-free growth -- the withdrawals wouldn't be taxed at all. Got that?

I hope you're keeping up, because things get more complicated. Many workers will be confronted with that "now vs. later" debate when they sign up for their employer-sponsored retirement plan. Why? Beginning this year, employers are able to offer the Roth 401(k), a retirement plan for for-profit companies, or the Roth 403(b), a retirement plan for nonprofits -- bless their hearts, unless they're lobbying organizations for evil people.

This is good news for many people, especially for those who are not eligible for the Roth IRA. However, don't think that all the rules about the Roth IRA are the same for the Roth 401(k) or 403(b). What are the differences? Let us count the ways.

Who's eligible
The Roth IRA is limited to single folks with adjusted gross incomes below $110,000 and married folks with AGIs below $160,000. Not so with the Roth 401(k)/403(b). There are no income restrictions; the only requirement is that your employer has to offer a Roth plan.

How much you can contribute
For 2006, the contribution limit to Roth IRAs is $4,000 and an extra $1,000 for those 50 and older. The limit to the Roth 401(k)/403(b) is the same as for its traditional forbear: $15,000, with an extra $5,000 for the 50-and-older crowd.

Required minimum distributions
With a traditional IRA and 401(k), investors must begin taking money out -- known as "required minimum distributions" (RMDs) -- in the year following the year they turn 70 1/2, whether they need it or not. (People who are still working can delay RMDs from the employer's retirement plan.) One of the benefits of the Roth IRA, however, is a lack of RMDs; the money grows tax-free until you need it.

Not so with the Roth 401(k)/403(b). Retirees will have to take RMDs, just as with a traditional 401(k)/403(b). However, if retirees roll their assets over to a Roth IRA, the nuisance of RMDs disappears.

What comes out first
One of the lesser-known benefits of the Roth IRA is that you can withdraw contributions at any time, tax- and penalty-free. That's because the money that comes out of a Roth first is the money you put in, and since you've already paid taxes on that money, Uncle Sam shouldn't tax you twice. However, once you've withdrawn the money you've contributed, any earnings that come out before the account has been open for five tax years or before you're age 59 1/2 or older -- whichever is later -- will be taxed as ordinary income and assessed a 10% penalty.

With the Roth 401(k)/403(b), however, the money that comes out first is a proportionate amount of contributions and earnings. So if the account is worth $10,000, $8,000 of which was contributions, then the first withdrawal will be 20% earnings. Those earnings will be considered tax-free as long as (again) the account has been open five years and the investor is at least 59 1/2.

A few other quirks
With the Roth 401(k)/403(b) being so new, rules and regulations are still being worked out. But here are a few funky facts about the Roth 401(k)/403(b):

  • Employer match: Regardless of whether you choose a Roth or traditional plan at work, any employer match will be contributed to a traditional plan. So, if you choose a Roth 401(k)/403(b), you'll essentially have two accounts -- one with your contributions, and one with your employer's match.

  • That five-year clock: If you roll over your 401(k)/403(b) to a Roth IRA that was opened for that purpose, the five-year clock on earnings begins anew. In other words, you can withdraw the contributions immediately, but you'll have to wait five years on the earnings -- even if you're older than 59 1/2. However, if you roll the money over to a Roth that had already been open for five years, then you don't have to worry about the five-year rule.

  • It may not last forever: The Roth 401(k)/403(b) was established by the Economic Growth and Tax Relief Reconciliation Act of 2001. And like many of the goodies in that act, the Roth 401(k)/403(b) is subject to a "sunset" provision -- that is, it ends unless Congress does something. In this case, the Roth 401(k)/403(b) sunsets in 2011.

Which to choose?
So, what's worth more -- a tax break now or a tax break later? The answer varies from investor to investor, depending (at least theoretically) on the differences between today's tax bracket and the bracket in retirement. The standard advice is, if you're in a much higher tax bracket now than you'll be in retirement, then go with the traditional 401(k)/403(b). But remember -- for that to really work out, you have to invest that tax savings, not spend it.

Another argument these days is that tax rates are at their lowest points in a generation. And given the country's growing deficits -- both in budgets and entitlements (e.g., Medicare and Social Security) -- many folks think taxes have nowhere to go but up. If you think that's the case, stuff as much as you can in a Roth, while you can.

All that's a discussion for a future article. But if a Roth 401(k)/403(b) is available to you and you can't decide whether to contribute, split your contributions between a traditional and Roth employer plan. You can contribute to both, as long as the combined deposits don't exceed the aforementioned contribution limits.

Robert Brokamp is the editor oftheMotley Fool Rule Your Retirementservice, featuring an online financial-planning tool and a monthly newsletter full of retirement goodness. Sign up today and receiveThe Motley Fool International Stock Reportfree.


Read/Post Comments (0) | Recommend This Article (6)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

Be the first one to comment on this article.

Sponsored Links

Leaked: Apple's Next Smart Device
(Warning, it may shock you)
The secret is out... experts are predicting 458 million of these types of devices will be sold per year. 1 hyper-growth company stands to rake in maximum profit - and it's NOT Apple. Show me Apple's new smart gizmo!

DocumentId: 503461, ~/Articles/ArticleHandler.aspx, 11/25/2014 6:21:02 PM

Report This Comment

Use this area to report a comment that you believe is in violation of the community guidelines. Our team will review the entry and take any appropriate action.

Sending report...

Robert Brokamp
TMFBro

Today's Market

updated Moments ago Sponsored by:
DOW 17,814.94 -2.96 -0.02%
S&P 500 2,067.03 -2.38 -0.12%
NASD 4,758.25 3.36 0.07%

Create My Watchlist

Go to My Watchlist

You don't seem to be following any stocks yet!

Better investing starts with a watchlist. Now you can create a personalized watchlist and get immediate access to the personalized information you need to make successful investing decisions.

Data delayed up to 5 minutes


Advertisement