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Weighing The Benefits Of Investing In A Roth 401(k)

Before the passage of the Pension Protection Act of 2006 (the PPA), there was a big asterisk attached to the Roth 401(k). The new option for retirement savers, which took effect in January, 2006, was scheduled to disappear at the end of 2010. But the PPA removed that sunset provision. So, now that you can be sure the new Roth 401(k) will be around for a while, would it make sense for you?

A new twist on a well-traveled savings vehicle. With a traditional 401(k) retirement plan, you get a tax break now on the money deferred from your salary, and your plan investments grow without being taxed. But when you withdraw money during retirement—you must begin taking distributions after age 70½—every dollar you take out is taxed as income.

That’s usually a pretty good deal. But for increasing numbers of workers, it’s no longer the only option. If your employer offers the Roth 401(k), you can turn the tradeoffs upside down. With a Roth 401(k), there’s no deduction for contributions. Once you’ve paid tax on money going into the plan, however, the assets and any growth are never taxed again. Withdrawals you take once you reach age 59½ (and after you’ve had the plan at least five years) are tax-free income.

Is it better to pay now or later? One crucial consideration in weighing the two saving options is your tax rate—now and in the future. If you expect to be in the same or a higher tax bracket when you retire, a Roth 401(k) could maximize your savings. However, if you think you’ll earn less and be taxed at a lower rate after you stop working, it may be preferable to take your tax deduction now on a traditional 401(k) rather than to receive tax-free income later. The younger you are the more compelling the Roth 401(k) is likely to be.

Tax rates are currently the lowest they’ve been in decades, and they could get bumped higher before you retire. Moreover, if a deduction for home mortgage interest is helping keep you in a low tax bracket now, you could find yourself paying tax at a higher rate during retirement, when your house may be paid off.

You can’t invest what you’ve sent Uncle Sam. You may also want to factor in the real cost of making after-tax contributions today, as well as any appreciation and income you might have earned on the money that goes for taxes. For example, the maximum annual contribution to a 401(k) in 2009 is $16,500, or $22,000 if you’re 50 or older. If you’re in the 33% federal tax bracket, you’ll need about $36,000 to make that $22,000 contribution with after-tax dollars. Had you been able to invest the difference, instead of paying immediate taxes, it could have compounded into a substantial sum by retirement. But of course those additional savings would result in extra taxes later, when you’re required to take withdrawals from your traditional 401(k).

Rollovers and conversions expand opportunities—and complications. Although both kinds of 401(k)s have minimum required distributions during retirement, the withdrawals from the Roth 401(k) aren’t taxed. Also, you’re allowed to roll over a Roth 401(k) to a Roth IRA, and the latter doesn’t force annual withdrawals at age 70½. And now, thanks to the PPA, a traditional 401(k) can be converted to a Roth IRA provided that your adjusted gross income is less than $100,000 (and the $100,000 limitation expires in 2010). As when you convert a traditional IRA to a Roth IRA, the 401(k) conversion means you’ll pay income tax on the amount that had been in the traditional account. But withdrawals from the Roth IRA won’t be taxed.

The question of where to direct your 401(k) contributions needn’t be an either/or proposition. As long as your employer offers both kinds of plan, you can contribute to both, though your total combined contribution can’t exceed the current $16,500 or $22,000 limit.

Sorting out all of these issues and calculating the dollar impact of the various tradeoffs isn’t straightforward or simple. If you’re considering the new Roth 401(k), give us a call and we’ll help you decide what works best in your situation.


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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