A traditional 401(k) plan lowers your taxable income as you save for your retirement. Only once you start receiving distributions from the account, usually at retirement, do you pay taxes on that money.
The new Roth 401(k), taking effect on January 1, 2006, combines the future tax benefits of a Roth IRA with the features of your employer's 401(k) plan. Where a traditional 401(k) takes out your contribution before your salary is taxed, the Roth 401(k) takes out contributions after taxes. When you retire, the withdrawals you make from your Roth 401(k) will be tax-free. Because money grows at compounded interest, the possible tax savings could be worthwhile.
The Roth 401(k) has potential benefits for:
Younger workers or those in lower tax brackets. As they build their careers, their incomes may grow as well, which could put them in a higher tax bracket at retirement.
People in higher tax brackets because of their age or career track. Many can't participate in a Roth IRA because their income, or their and their spouse's combined income, is too high for a Roth IRA. The salary limits on the traditional Roth do not apply to Roth 401(k)s.
It is your employer's decision whether it will offer the Roth 401(k) to you. You should know that:
- The Roth 401(k) has the same contribution limits as a traditional 401(k): $15,000 for 2006, with an extra $5,000 catch-up provision for people age 50 and older. You can designate contributions to your 401(k) account as Roth 401(k) contributions, or you can split the money between both types of accounts. But your total contribution to both cannot exceed these limits.
- You must have your Roth 401(k) account for five years. Your specific plan will tell you when you can begin collecting money penalty-free; otherwise, early withdrawals get penalized at 10 percent.
- Any 401(k) match by your employer to your Roth 401(k) will be on a pretax basis and will be taxed upon withdrawal.
- The Roth 401(k) is not yet a permanent option. This is because no one can foresee how this will affect tax revenue. If Congress ends the Roth 401(k) in 2010, you will be able to roll the money into a regular Roth IRA. But you won't be able to make further Roth 401(k) contributions.
- Your tax savings will depend upon your future tax bracket, earnings, and marital status. But, in recent years, the government has reduced tax rates and the number of brackets. There is no guarantee that you'll benefit from a Roth 401(k) just because you'll suddenly be in a lower tax bracket after retirement.
What should you do? Can you afford to postpone the immediate tax benefits of a regular 401(k) in exchange for the future gratification of tax-free withdrawals when you retire? That's up to you and your financial professional.