Updated: May 3, 2013 12:14PM
Originally published: June 13, 2005
Man’s new best friend could be Roth 401(k)
What do you get when you cross a labrador with a poodle? It’s called a “labradoodle,” a very cute dog I was introduced to last week. Now, what do you get when you cross a Roth IRA with a 40l(k) plan? You get a Roth 40l(k) -- and it’s no dog of an investment. It’s a new opportunity that will face employees in January 2006.
Companies will be offering employees a choice: You can continue making a pre-tax contribution to your company 40l(k) retirement plan. That means you’ll pay taxes on all the money you withdraw at retirement, with the amount of tax depending on your tax bracket at that time.
Or, your employer may offer you the chance to make an after-tax Roth contribution to your company retirement plan. In effect, you’re contributing to a Roth 40l(k). And since you’ve paid taxes on the contribution, that money and all the growth of your investments over the years, will come out completely tax-free.
Complicated but worth it
Yes, it’s complicated. Since employees will be allowed to split their contributions between traditional pre-tax IRAs and new Roth 40l(k) after-tax plans, the record-keeping will be challenging. But major plan custodians, such as Vanguard, are already gearing up to provide the computer systems to enable this new dual system, according to Steve Utkus, director of the Vanguard Center for Retirement Research.
Says Utkus, “The real challenge will be for employees to decide which type of contribution to make.”
We’ve all been taught the importance of pre-tax savings, growing tax deferred in the traditional 40l(k) plan. The idea is to pay the taxes later, after retirement, when you’ll surely be in a lower tax bracket.
But that’s not necessarily the case. In fact, many people -- lower-income as well as higher-income workers -- might be far better off paying the taxes right now, and making an after-tax contribution to this new type of Roth 40l(k) plan.
Young, low income workers: If you’re just starting your career, you’re probably in the lowest tax bracket -- 10 percent. You expect to make more money in the future. It makes sense to pay the tax now on your 40l(k) contribution at a 10 percent rate, so that the withdrawals in future years will be tax-free.
Young families: There are so many good deals with tax credits for simply having children, or credits for the cost of child care, or even the earned income tax credit that some families can earn $40,000 a year or more, and effectively pay no tax. They’ll be better off with after-tax contributions and tax-free withdrawals.
Very high wage earners: If you’re already contributing the maximum to your company 40l(k) plan, you’ve probably built up quite a lot of tax-deferred retirement savings. Just for the sake of diversification, you’ll probably want to make your 2006 contributions in an after-tax Roth format, if your company allows. After all, you don’t know what tax brackets will be in effect when you retire.
Companies aren’t required to offer the Roth 40l(k) alternative. But when they realize the benefits to lower-paid and younger workers, they may feel a lot of pressure to include the Roth 40l(k) option.
If you are given the opportunity, here’s what you should consider:
*How much to contribute? For 2006, the maximum contribution to a company plan is $15,000, or $20,000 if you’re 50 or older. Studies show that the median annual contribution to company plans is about $3,600. Try to increase your contribution, even on an after-tax basis.
Company matching funds
*What about the company match? If your company matches part or all of your contribution, that portion of your plan will always be considered a pre-tax contribution, subject to ordinary income taxes at retirement.
*What investment choices? You’ll have the same investment choices for pre-tax and after-tax contributions, and you still need to diversify.
*Pre-tax or after-tax (Roth) contributions? Consider your current tax bracket, and the one you think you might be in at retirement. Now you can diversify your future tax liability.
*What if the government reneges on its promise to let you withdraw money tax-free from a company Roth 40l(k) plan?
The answer is in the numbers. If enough of us choose to invest after tax, we’ll have all the political pull necessary to force it to keep its word on tax-free withdrawals. If it doesn’t, our labradoodles will get them! And that’s The Savage Truth.
Terry Savage is a registered investment adviser. Distributed by Creators Syndicate.