To Roth, or not to Roth…

February 27th, 2008 at 11:09am Jerry Korabik

 Jerry S. Korabik, CFP®, AIFA®

…401k,  that is the question.  Does your plan offer a Roth 401k feature, if not, it might soon.  Congress gave Plan Sponsors the benefit of Roth 401k effective January 1, 2006 and though it started gaining popularity slowly, we see this feature really gaining some steam in the coming years.  The Roth feature is a no brainer for most companies to add this to their current plan offerings.  If your employer has a traditional 401k plan already established, it’s a simple “flipping the switch” to make this account feature available to you.  A few extra forms to fill out and you now have another option to save effectively for retirement.   

The Basics: 

The Roth 401k is an additional bucket used to save for retirement.  Traditional 401k allows for tax-deferred contributions and tax-deferred earnings.  Roth 401k taxes your contributions now, but your earnings grow tax-free throughout your working years and during retirement and possibly beyond.  Employee contribution limits for 401k plans in 2008 are set at $15,500.  If your plan offers both Roth and traditional 401k, the combined limit is also $15,500 to both plans together (not including any employer match) which means if you contribute to both parts of the plan, you cannot exceed that dollar amount.  For example in my plan, I may contribute $10,000 to my Roth 401k and $5,500 to my traditional 401k and I would meet the requirements.  If you left your employer you can also rollover your traditional 401k to a traditional IRA and a Roth 401k to a Roth IRA to give you maximum control of your retirement dollars.

In addition to tax-free earnings, the Roth feature is also not subject to age 70 ½ Minimum Required Distribution rules as traditional 401k and IRAs are.  So if you don’t need the money in your Roth bucket during retirement, you aren’t forced to take it out and you can pass it on to your heirs free of income tax.

Having the Roth gives you more flexibility in post-retirement years on how you may want to spend down your retirement portfolio.  Consider an investor with a traditional tax-deferred 401k, a Roth 401k and a taxable account.  As you accumulate wealth in those 3 different buckets, it gives you more flexibility in a post-retirement setting to spend down the assets and to an extent, limit your tax liability from year to year.  Why?  Because each of those buckets face different tax rates.  Your traditional 401k which has never yet been taxed, will be taxed at your highest marginal income tax rate when the money comes out in retirement.  Currently, that rate is 35%.  Who knows what it will be when you retire.  Your taxable accounts (like personal investments) will face capital gains taxes when sold.  Current capital gains taxes are as low as 15% for most taxpayers, and even 10% for others.   Of course, the Roth 401k will face no taxes when it comes out in retirement.

Who might consider the Roth 401 (k) feature?  The typical answer is “it depends.”  However, below are a few examples or who might benefit more from a Roth 401k today:

1) Participants that are now in a low tax bracket, but expect to be in a higher bracket in retirement.  Makes sense to pay the taxes on the contributions now and take out tax free earnings later in life.

2) Participants that feel retirement savings will be taxed at a much higher rate than current contributions.  If you are concerned about future higher tax rates overall on your retirement nest egg, it might make sense to do a Roth.

3) Participants unable to make “Roth IRA” contributions due to regulatory limits

If you don’t qualify for $5000 Roth IRA contributions because your income is too high, relax as there are no income limits for those in a Roth 401k plan, you can put up to $15,500.

Check with your Plan Sponsor if you aren’t sure whether your plan offers this feature. If your plan offers this feature, test drive it first, because your income taxes will go up initially as more of your income is being taxed now, and you will need to get used to a different sized paycheck than maybe what you had before.  Over the long-term, the Roth feature could be a nice benefit for you.

Entry Filed under: Financial Planning, Investments