Retirement investors, may I introduce you to a new friend? You're surely familiar by now with our old friends, the traditional IRA and the not-so-newfangled-anymore Roth IRA. (If not, get the scoop on them in our IRA Center -- odds are, you need to have a growing IRA under your belt. We can explain why and how to do so.) And you have surely heard of 401(k) accounts -- you very likely contribute to one at work. (Read all about 401(k)s and how to maximize them.) Well, there will soon be a new kid on the block: the Roth 401(k).
If you're a savvy investor, you probably don't need to know much more. You can put two and two together and understand that the Roth 401(k):
- Will be a plan offered by employers to employees.
- Will accept post-tax contributions, unlike traditional 401(k) plans that take your pre-tax money, effectively reducing your taxable income by the amount of your contribution.
- Will therefore not reduce your taxable income by the amount of your contribution.
- Will offer you the exciting benefit of tax-free withdrawals (after age 59 1/2 and after five years of deposits).
Here are some things you may not know yet:
- The new plans will be available to many employees beginning Jan. 1, 2006.
- Employers will still be able to offer traditional 401(k)s, and employees may split contributions between the two types of plans.
- Employer contributions, though, may go only into traditional 401(k) plans.
- Whereas there are no minimum withdrawals with Roth IRAs, Roth 401(k)s, like traditional 401(k)s, require you to begin withdrawing from them beginning at age 70 1/2.
- Not every company will immediately be offering a Roth 401(k). A Hewitt Associates (NYSE:HEW) study found that about a third of employers plan to offer them immediately.
- When you leave your job, you can roll over your Roth 401(k) into a Roth IRA. (Robert Brokamp recently lamented, in 9 Retirement Killers, how too many people just cash out 401(k)s instead of rolling them over.
In case you still don't get the gist of this new offering, consider this example. Let's say you earn $60,000 per year. If you plunk $6,000 of your salary into a traditional 401(k), that amount is deducted from your taxable income. So instead of being taxed on $60,000, you're taxed on $54,000, and that means a lower tax bill. You get an immediate tax benefit (well, within a year, anyway). If your tax bracket is 25%, you'll avoid paying $1,500 in taxes.
Meanwhile, if you instead park that $6,000 into a Roth 401(k), your taxable income remains $60,000. Your tax break comes later -- possibly much later. Let's say your money grows in that Roth 401(k) for 10 years and is then rolled into a Roth IRA when you change jobs. In an IRA, you can invest in individual stocks as well as a wider variety of funds than your 401(k) probably offered. So if you admire Procter & Gamble's (NYSE:PG) annual stock price growth rate of about 13% over the past decade (not even including dividends) and expect solid growth in the future, you can invest directly in it via your IRA instead of having to settle for some fund which may or may not invest in a little bit of P&G. Imagine now that your $6,000 earns an average of 11% per year for 25 years. If so, it will grow to around $81,500 -- which you can withdraw tax-free! That's the beauty of the Roth 401(k) and Roth IRA.
Learn more about the Roth 401(k) in this TMF Taxes article and about Roth IRAs in this Robert Brokamp article. And be sure to drop by our IRA Center, too, to learn all about IRAs, which are the best bets for many retirement savers.
If you fear you don't have your ducks in a row in preparation for retirement, take a free trial subscription to Motley Fool Rule Your Retirement by clickinghere.
Longtime Fool contributor Selena Maranjian does not own shares of any companies mentioned in this article.
