I've heard about a new Roth 401(k) account. Could you please explain the details, and who is eligible?
Beginning on Jan. 1, 2006, a 401(k) plan will be able to offer a Roth feature with the same basic attributes as the current Roth IRA. But in the new 401(k) version, anyone – regardless of annual income – will be able to contribute, and the maximum contribution amounts per year will be much greater: $15,000, plus another $5,000 "catch-up" for anyone over 49 years of age.
Within these maximums, a typical 401(k) plan will give participants the option of having their contribution be pre-tax as usual or after-tax (the Roth treatment). This year's Roth IRA maximums, by comparison, are only $4,000, plus another $500 for those over age 49. High-income taxpayers can't contribute to today's Roth IRA at all, but the Roth 401(k) will have no such limitation.
Investors will be able to contribute to a traditional 401(k), Roth 401(k) or a combination of the two. If you choose to contribute to both, you do not get to contribute twice as much money, as contribution limits remain the same regardless of whether you choose a traditional account, a Roth or both.
The advantage of a Roth contribution is that all the money taken out at retirement is totally tax-free. The annual contributions are made with after-tax dollars, and this may be a hurdle for some, but the prospect of tax-free distributions for you or your heirs at what might be a generation away is too good to be true.
Someone contributing $3,000 a year to a Roth and earning an average of 12 percent a year in small-cap stocks will have $909,000 in 30 years. At an 8 percent return, they would accumulate $372,000. In either case, their total after-tax contribution would only have been $90,000; all the excess would have been spendable, tax-free cash.
Most people get excited about the deductibility of what they contribute to retirement plans, but these numbers illustrate how valuable the tax-free build-up and eventual tax-free distributions can be. In another example, $10,000 per year for 20 years at only 8 percent accumulates to more than $500,000. The contributions total $200,000, and the tax-free spendable earnings add up to $300,000.
Opening New Windows
Roth 401(k) accounts open several new windows of opportunity to save taxes and pass more money on to heirs. Many people today may not have the income to support what the law allows as maximum annual contributions to 401(k) plans, but someone with after-tax savings or some inherited money could consider spending that money on living expenses while they contribute equally to the Roth.
This effectively turns taxable compounding of investment earnings on after-tax money into earnings that will never be taxed. Moreover, money in a retirement plan can be invested more effectively when investment changes and reallocations can be conducted without triggering taxes on profitable trades.
Also, Roth 401(k) money can be rolled over to a Roth IRA if the participant leaves the company, relieving the participant of having to take out mandatory distributions at age 70. If this is done before someone dies, that money then inherited by children (or grandchildren) will enjoy the Roth characteristics that would allow it to grow tax-free in what would become Roth IRA accounts.
The decision regarding which plan to choose will depend largely on your personal financial situation.
Craig G. Langweiler is president of the Langweiler Financial Group in Newtown. He can be reached at: [email protected]