Roth 401(k) Is Here. Is It Right For Me?
By Sylvia Bell, JD, Alpern Rosenthal
When offered the option of a Roth account in the 401(k) plan, as participants,
we encounter a difficult choice. Should we contribute to a Roth 401(k)
and forego the current benefit of a reduction in the taxation of our
take-home pay (since Roth contributions are made with after-tax dollars),
or remain with a traditional pre-tax 401(k) salary deferral and hope
that in retirement, our individual tax rate will be lower than it is
now? Alternatively, if we want both benefits of current reduction of
taxation of our pay and the receipt of tax free retirement income, we
might want to play it safe by contributing to both Roth and pre-tax
401(k) accounts.
Generally, making a fiscally wise decision depends on an informed,
rational approach to a situation involving risk. In this case the unknown
risk is whether your individual tax rate will increase or decrease.
Since, there is no absolute answer to that question, we must rely on
a reasonable estimation of the taxes that we anticipate in retirement.
This estimation is based on several factors including our speculation
of the general tax rates in the future and an assessment of the other
sources of our current and future savings which will be income in “golden
years”.
If we expect that the tax rate will be approximately the same or higher
in retirement than we’re paying now, it might be time to consider
allocating some or all of our salary deferral to the Roth 401(k). If
we are part of the generation that grew up with cell phones and cds,
we most likely anticipate our income to increase as we climb the ladder
of success in the workforce. If our current tax bracket is currently
10%, 15% or maybe even 25%, it may be a wise choice to pay the tax now,
make some or all of salary deferral into the Roth account.
Obviously, predicting future circumstances, including tax rates, is
nearly an impossible task. The general consensus is that taxes and/or
tax rates are not likely to decrease but are more probable to increase
to pay for rising Social Security and Medicare costs. The decision between
contributing to a Roth or a traditional account is complicated by both
personal and national budgetary concerns.
1. Who is eligible for a Roth 401(k)?
Anyone whose employer offers it. Inside a 401(k) plan, the contributions
to the Roth are not limited by the AGI limits. Employers may elect to
offer the Roth option, it isn't required. Among the major concerns for
employers are the costs associated with managing the plan, and educating
their workforce about this new investment option. Companies are more
likely to offer a Roth 401(k) if their employees indicate that they
intend to participate.
2. What happens to the employer match?
Employer matches will still be made with pretax dollars, and the match
will accumulate in a separate account that will be taxed as ordinary
income at withdrawal.
3. What are the early withdrawal rules?
Early Roth 401(k) withdrawal rules will be subject to the same requirements
as traditional 401(k)s.
4. What happens at the termination of employment?
The Roth 401(k) balance can be rolled over into a Roth IRA.
5. Is the Roth 401(k) option here to stay?
Yes. The Pension Protection Act of 2006 made all of the Economic Growth
and Tax Relief Reconciliation Act of 2001 provisions permanent. If the
employer offers the Roth 401(k), participants have a choice to make:
the entire deferral into the traditional 401(k) account, all in a Roth
401(k) account, or split between the two. Here's how they compare.
Different Tax Treatment
Contributions to a traditional account 401(k) account reduce the individual’s
income for the year (less amount of income to report on the Form 1040),
which translates to a smaller tax bill in the year contributions were
made – the individual pays the tax upon receipt of the deferrals
and earnings as a retirement benefit. There is no Pennsylvania tax upon
receipt (in retirement) because Pennsylvania doesn’t recognize
the tax deduction for 401(k) salary reductions.
Contributions to a Roth account don't reduce the taxable income and
therefore don’t reduce the tax in the year of the contributions,
but all the earnings in the Roth account are tax-free for as long as
the account exists. Furthermore, at the termination of employment you
can roll your Roth 401k account to a Roth IRA, so the account can continue
to grow with tax-free earnings for as long as you choose to preserve
it.
No Difference in Contribution Limits
Roth 401(k) limits are the same as traditional 401(k) account limits.
There is a single limit that applies to the overall total you contribute
to both types of accounts. For example in 2007,, the limit is $15,500,
it can be allocated to either type of account or split it between the
two types, but the total contribution to both types can not exceed $15,500.
No Difference in Investments
Generally the investment opportunities are the same for Roth 401(k)
account as for traditional 401(k) account.
No Difference in Matching Contributions
If the employer provides matching contributions for retirement savings,
the match will be the same for Roth 401(k) contributions as for traditional
401(k) contributions – the only difference is that the matching
money must go into a traditional 401(k) account.
Why choose a Roth 401(k) account?
The simplest reason is that the tax rules allow employees to accrue
a Roth account just as large as a traditional account, but at retirement
the Roth account will be more valuable because it will not be taxed
at distribution.
The Roth Account Is More Valuable
It does appear that the Roth account is more valuable at retirement.
Distributions from a traditional account are taxable (Federal), but
distributions from the Roth account are not. The difference can be surprisingly
large. For example, if an individual is in the 25% tax bracket, he would
have to withdraw $133.33 from a traditional account to have $100 in
spending money, because $33.33 will be used to pay tax on the distribution.
Summary
To simplify, choosing the Roth means paying more tax in the year of
the contribution, because a Roth contribution doesn't reduce your taxable
income. Electing to contribute to the traditional 401(k) provides an
immediate tax reduction because the contributions are made pre-tax.
Planning for our future is a task which could have significant rewards
if we forecast correctly. If we have a choice as to the type of account,
we need to take some time and make the decision and in any event, don’t
just sit back and let it happen to us.
Sylvia Bell, JD, is the Senior Manager of Employee Benefits Services
for Alpern Rosenthal. She can be reached at 412.281.2501, ext. 335 or
at sbell@alpern.com.
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