The New Roth 401(k): A Roth IRA on Steroids

Larry Holmes

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Beginning on January 1, 2006, the new Roth 401(k) plan becomes available. It will be an exciting development because it will allow millions of Americans to not only have tax-free savings and investments while working, but tax-free income during retirement.

Of course, we already have Roth IRA's that give us those tax advantages. But think of the Roth 401(k) as like the Roth IRA on steroids. The new plan has the same appeal of a regular Roth IRA - tax-free investments and retirement income - but with much larger annual maximum contributions allowed and no income ceiling.

Anyone will be able to contribute up to $15,000 per year plus another $5,000 for those over 49 years of age. That's much more than can be contributed to a Roth IRA. For 2006, the contribution limit to a Roth IRA is $4,000 for people under age 50 and $5,000 for those 50 and over. And, whereas the full benefits of a Roth IRA is limited to those who have incomes no higher than $95,000 for single people and $150,000 for those who are married, the Roth 401(k) has no income ceiling at all.

With the Roth 401(k), you don't get the upfront tax deduction that you get with traditional 401(k) and IRA plans. But, for many people planning for retirement, the ability to make tax-free withdrawals during retirement should more than offset the lack of an initial tax-deduction.

The conventional wisdom is that if you think you're going to be in a lower tax bracket when you retire, you're better off getting the upfront tax deduction of a traditional 401(k) and pay the taxes when you withdraw your money. On the other hand, if you think you're going to be in the same or higher tax bracket during retirement you're much better off with the new Roth 401(k).

Many people assume they will be in a lower tax bracket when they stop working. But it may not happen that way. Over the last 25 years, the top marginal federal tax rate has dropped from 70% to 35%. At the same time, tax brackets have broadened, the use of tax credits have spread, and the tax treatment on retirees’ Social Security checks has changed. These trends have increased the odds that many retirees will be in the same tax bracket or higher at retirement. Also, with a traditional 401(k) you're not avoiding taxes by getting being able to contribute pre-tax income. You're simply deferring your tax obligation to the future.

If you're not sure whether you're better off with the tax deduction now or the tax-free income later on, you could always split your contributions by investing in both a regular 401(k) plan and the new Roth 401(k).

Having said that, if I had to bet one way or the other, I'd bet that most of us are going to be in higher tax brackets during retirement. If so, the advantage clearly goes to the Roth IRA.

(c) Larry Holmes

Larry Holmes invites you to visit Your common sense guide for financial and investment success.


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