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Traditional and Roth 401Ks

Selecting the right Retirement Plan

The Roth 401(k) may appeal to workers willing to forego a tax break now in return for getting one at retirement. As its name implies, the Roth 401(k) combines features of a traditional 401(k) with those of a Roth IRA.


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Like a traditional 401(k), workers enjoy the convenience of contributing through payroll deductions. But similar to a Roth IRA, contributions are made on an after-tax basis and withdrawals after age 59 1/2 are tax-free and penalty-free for workers who have maintained their account for five years. There is also a Roth 403(b) plan for workers in the nonprofit sector.

How a Roth 401(k) WorksThe Roth 401(k) follows many of the same rules as a traditional 401(k). For the 2006 tax year, federal laws permit a maximum annual contribution of $15,000, although your employer may impose a lower limit. Your employer may provide a matching contribution as part of a Roth 401(k) offering, although you will be required to accept the matching contribution in a traditional, and not a Roth, account. If you are age 50 or older, you may contribute an additional $5,000 for a total of $20,000 in 2006.

You may continue to maintain a traditional 401(k) while directing all or a portion of new contributions to a Roth 401(k). Your contributions to a Roth 401(k), however, are irrevocable once made, they cannot be transferred to a traditional 401(k) account and funds in a traditional 401(k) cannot be switched to a Roth 401(k). Both Roth and traditional 401(k)s require distributions after age 70 1/2.

Planning for RetirementA Roth 401(k) may present a significant benefit when it's time for retirement the funds can be rolled over directly to a Roth IRA with no tax payment, a feature that is currently not available with a traditional 401(k) account. A traditional 401(k) must first be rolled over to a traditional IRA and the traditional IRA then converted to a Roth IRA, although such conversions will be possible beginning in 2008. A Roth IRA conversion requires you to pay taxes on the portion of the rollover that has not yet been taxed.

Roth 401K vs. Traditional 401(k)

A Quick ComparisonThe table below presents a summary of the most important differences between Roth and Traditional 401(k)s.

What Traditional 401k Roth 401k
Tax Status of Contributions Pretax contributions reduce current taxable income. After-tax contributions do not affect current taxable income.
Tax Status of Distributions After Age 59 Taxed as current income. Tax free and penalty free for investors who have had the account for at least five years.
Rollovers to IRAs Must currently be rolled over first to a traditional IRA, then converted to a Roth IRA, which requires a tax payment. May be rolled over directly to a Roth IRA with no tax payment.

To Roth or Not to Roth?

If you're considering a Roth 401(k), you may want to review the following points before making your decision:

  • Although future tax rates are difficult to predict, you may benefit from a Roth 401(k) or 403(b) if you anticipate being in a higher tax bracket during retirement.
  • Even if your marginal tax rate remains relatively stable, you may face a higher tax bill in retirement if you no longer claim deductions for dependents and mortgage interest, as well as other deductions frequently utilized by families. If this sounds like a likely scenario, a Roth 401(k) may be to your advantage.
  • Will you need your retirement assets for living expenses during your later years? If not, a Roth 401(k) offers the opportunity to roll over funds directly to a Roth IRA, which does not require distributions after age 70 1/2. This situation may enhance the potential tax-free growth of your assets and enable you to bequeath a larger portion of your assets to your heirs.
  • You are not required to meet income thresholds to participate in a Roth 401(k). Roth IRAs are limited to single taxpayers with $110,000 and married couples with $160,000 or less in adjusted gross income. A Roth 401(k) may have some appeal if you desire tax-free withdrawals but your income exceeds the threshold for a Roth IRA.
  • The longer you remain invested in a Roth 401(k), the more you are likely to benefit from tax-free growth. If you plan to retire in five years or less, a shorter-term time horizon may limit the benefit of tax-free withdrawals, whereas your account may get a bigger boost from tax-free savings if you plan to continue working for a longer period of time.

Capitalizing on every option available to you may make it easier to pursue your long-term savings goal. If tax-free withdrawals could potentially benefit you, and your employer makes a Roth 401(k) available, consider adding it to your retirement planning mix.

Summary

A Roth 401(k) offers the option of investing for retirement on an after-tax basis. In return for foregoing a tax deduction when the contribution is made, participants are able to make withdrawals free of penalties and income taxes during retirement.

Workers may elect to make all or a portion of their 401(k) contribution to a Roth 401(k). Once made, however, a contribution cannot be transferred to a traditional 401(k) and assets in a traditional 401(k) cannot be switched to a Roth 401(k).

The annual maximum contribution for 2006 is the same as for a traditional 401(k): $15,000 plus an additional $5,000 catch-up contribution for employees aged 50 and older.

Employers who provide a matching contribution are required to allocate the match to a traditional 401(k), not a Roth account.

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