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The Roth 401(k)

The Roth 401(k)

Beginning January 1, 2006, employers may (but are not required to) offer their employees a new retirement savings option called a Roth

401(k). As its name suggests, it will combine features of the traditional 401(k) plan with those of the Roth IRA.

As with Roth IRAs, contributions will be made with post-tax dollars.

Goodbye upfront tax deduction! However, the account will benefit from tax-advantaged compounding and withdrawals taken in retirement will not be subject to income tax (provided you’re at least 59 ó and have held the account for at least five years).

As with traditional 401(k) plans, employer matching contributions will be made with pre-tax dollars and withdrawals taken in retirement will be taxed as ordinary income. To preserve their tax status, the funds will accumulate in a separate account.

Contribution limits (including the “over 50 catch-up contribution”) for Roth 401(k)s will be similar to traditional 401(k)s. For comparison purposes, consider that the contribution limit for a 401(k) in 2006 will be $15,000 (or $20,000 if making the over 50 catch-up) compared to $4,000 (or $5,000 if making the over 50 catch-up) for a Roth IRA.

At this time, it is unclear what the early withdrawal rules will be. It appears as though they will be identical to a traditional 401(k) plan.

However, regulations are not final.

Employees who leave their jobs will be permitted to rollover their account balances. In the case of a Roth 401(k), a Roth IRA will be the appropriate account to receive and hold the funds.

The upside to the Roth 401(k) is that anyone is eligible, regardless of income, as long as his or her employer offers this type of savings plan.

As such, it could be a tremendous benefit for high-income individuals who previously were shut out of Roth IRAs due to income restrictions.

The downside is that annual contribution limits pertain to both traditional and Roth 401(k) plans. An employee cannot save $15,000 in a traditional 401(k) and another $15,000 in a Roth 401(k).

Ultimately, the decision is not whether to save more but whether to save in an account with different tax treatment. Those who contribute to a traditional 401(k) will be betting that future ordinary income tax rates will be lower than those they face in their working years. Those who contribute to a Roth 401(k) will benefit from the tax-free treatment of the account but will take home less because of the post tax nature of the contributions.

While no one can predict with certainty what tax rates will be in the future, one must consider their likely direction given ever-increasing budget deficits, unfunded Social Security and Medicare obligations, etc. This argument bolsters the case for high-income individuals to participate in the Roth 401(k). Regardless of today’s income tax rates, paying tax today and benefiting from tax-free deferral/withdrawal is a nice offset to the uncertainty of future (and probably higher) ordinary income tax rates.

Those just starting out in their careers – typically recent college graduates – are also likely to benefit from a Roth 401(k) since starting salaries tend to fall in the lower tax brackets.

As always, it is important to make this and any other financial decision in the context of a comprehensive financial plan. Give us a call to see which type of 401(k) plan is best for you.

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