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Roth 401(k)s Allowable Starting in 2006
Starting next year employers will be permitted to offer employees the option to make contributions to their traditional 401(k) plan or to a new Roth 401(k) plan, or both.
Let's compare the benefits. First, the basics: the 401k allows employees to contribute $15,000 in 2006, plus another $5,000 if you are 50 or older.
The 401(k) contribution is subtracted from earnings, saving the marginal tax on that income. For the highest income taxpayers in California, that rate is 44% combined federal and state. The full $20,000 contribution would reduce your taxes by $8,800. But the money that you take out of the account, at retirement, is taxed as ordinary income in the year you take it.
People often expect to have lower taxable income in retirement than in their working years. The combined effects of the current year tax deduction, the years of tax deferral until you take the money out, and a lower tax rate at retirement make the 401(k) a desirable alternative.
The Roth 401(k) contribution does NOT reduce current taxable income and thus has no effect on your current year taxes. But when the money is finally taken out of the account, the withdrawals are not subject to income taxes. Roths do not have required minimum distributions, as 401(k)s and IRAs do.
There are three significant differences between Roth 401(k)s and Roth IRAs:
- you can contribute to your Roth 401(k) regardless of income; but contributions to regular Roth IRAs are allowed only if your income is less than $160,000 (joint filers) or $110,000 (single filers)
- you can contribute more to your Roth 401(k) than a Roth IRA: $15,000 in 2006 ($20,000 for age 50+) for the Roth 401(k) vs. $4,000 in 2006 ($5,000 for age 50+) for the Roth IRA
- you will be required to take minimum distributions from the Roth 401(k) starting at age 70, but minimum distributions are not required from Roth IRAs
In general, you would elect to make Roth contributions if you:
- expect a higher tax rate in retirement than now
- are close to age 70
Of course, the possibility exists that future tax laws may change so that Roth withdrawals are no longer tax-free. On the other hand, there is also the possibility that future tax rates become so high that you would have been better off foregoing the current deduction of a 401(k) for the future tax exemption.
Without trying to handicap the future actions of Congress, it seems that the AARP of the future would scream loudly if withdrawals from Roths become taxable in our retirement years.
Grubman Financial can help you optimize your contributions according to your specific financial circumstances. Feel free to ask for help!
