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The Roth 401(k) - Is It Right For You?

According to human resources consultant Hewitt Associates, only about 70% of employees participate in 401(k) retirement plans. One sticking point for non-participants is the long-term tax consequences of 401(k) distributions, which are taxed as income during retirement. But that concern could vanish for many workers thanks to the new “Roth 401(k)” This retirement planning vehicle made its debut on Jan. 1, 2006.

The biggest tax benefit of a traditional 401(k) comes at the outset, when your contribution reduces your taxable income. Investment earnings in the account also compound free from taxes. But when the money finally comes out, the entire amount is taxed as income, currently at a top rate of 35%. Contrast that with what happens to investments in taxable accounts. There, interest income is taxed at the income rate, but most dividends are subject to a top rate of 15%, which also applies to long-term capital gains.

The Roth 401(k) could shift those tradeoffs. The new 401(k) will function much like the standard variety, with payroll deductions and self-directed investments. But there’s a key difference. With a Roth 401(k), your contribution is part of your taxable income. Yet distributions during retirement are tax free and penalty free, provided the assets have remained in the plan for at least five years, and the distributions take place after age 59½.

Those characteristics make the Roth 401(k) similar to a Roth IRA. But you may contribute to a Roth IRA only if your income is below a specified ceiling—$169,000 for couples, and $116,000 for individuals in 2008. With a Roth 401(k), there’s no income limit, and participants can put away up to $15,500 in 2008, compared with just $5,000 for a Roth IRA ($6,000 if age 50 or over).

Like a standard 401(k)—and unlike a Roth IRA—the Roth 401(k) does require minimum distributions beginning at age 70½. With a Roth IRA, you never have to take withdrawals during your lifetime. Yet Roth 401(k) distributions won’t be taxed. Moreover, you can avoid taking distributions by rolling over your Roth 401(k) to a Roth IRA. (The IRS may close that apparent loophole.)

If your employer offers both a regular and a Roth 401(k), you may contribute to both, but your combined salary deferral can’t exceed the $15,500 maximum. And any matching contributions from your company go to the regular 401(k).

Which 401(k) is a better deal? It depends on your tax rates when the money goes in and comes out, as well as how long the money is invested and how much it earns. But for younger workers, in particular, the Roth 401(k) may be preferable.

Established as part of the 2001 tax bill, the provisions allowing Roth 401(k)s were initially set to expire in 2011. But the Pension Protection Act of 2006 made Roth 401(k)s permanent. The change is expected to increase interest in this 401k) variation.

 

 

This article was written by a professional financial journalist for Legend Financial Advisors, Inc.® and is not intended as legal or investment advice.


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