To Roth or Not to Roth?
If the term Roth 401k sounds strange to you, it’s probably because you’ve never heard it before. They’re brand new this year! Beginning in 2006, employers can offer Roth 401k plan options to their employees.
A word of caution
The regulations addressing some of the issues surrounding Roth 401(k)s are still being finalized. Before making any decision to participate, you should consult your investor coach or adviser.
A traditional 401(k) lets employees contribute money toward retirement on a pre-tax basis. This means contributed funds aren’t taxed until withdrawn at retirement. A Roth 401k, however, lets employees contribute after-tax money with the benefit of withdrawals at retirement being income taxfree.
Only employers can decide to offer a Roth 401(k) option to their employees. Assuming your employer offers a Roth 401(k) option, there is a choice to be made.
One of the major factors in the decision to choose a traditional or Roth 401(k) is whether employees think tax rates will rise in the future. If tax rates go up, it will be beneficial to have contributed funds that were taxed at today’s lower rate.
If an employee expects tax rates to fall, it makes sense to contribute to a traditional 401(k) because the funds will be taxed at the lower tax rate in the future.
Many economists expect the ballooning national deficit to eventually necessitate a rise in tax rates. Since we are presently enjoying near historic low tax rates, there is an argument that eventually rising taxes may be imminent.
Issues like required minimum distributions and the availability of hardship withdrawals are still being hammered out, and may prove to be important factors in the Roth vs. traditional 401(k) decision.
Roth 401(k)s bear some important similarities to their traditional brethren:
- The contribution limit is the same ($15,000 maximum in 2006).
- You generally have very restricted access to all (traditional 401(k) or a portion (Roth 401(k) of your account until age 591/2 without paying a penalty tax. There are a few exceptions and nuances, so see your investor coach if you have questions about this.
The availability of Roth 401k options may be limited because the law creating them sunsets in 2010 unless congress acts to extend it. This would mean no additional contributions could be made to your Roth 401(k) after that date, if Congress doesn’t extend it.
Additionally, employers cannot make contributions to an employee’s Roth 401(k). Because of this, all employer contributions (including matching contributions) must continue to be made to an employee’s traditional 401(k).
For example, Jerry Jenkins contributes $10,000 to his Roth 401(k) for 2006. Jerry’s employer offers a 30 percent matching contribution, which equals $3,000 in Jerry’s case. Because employers cannot contribute to Roth 401(k)s, the employer’s $3,000 contribution would be placed in a traditional 401(k) for Jerry, while Jerry’s $10,000 contribution would remain in his Roth 401(k).
The administrative headache of recordkeeping for two accounts for each employee may discourage employers from offering Roth 401(k) options to employees.
In closing, remember that the 2006 limit for total employee 401(k) contributions (both Roth and traditional) is $15,000. Therefore, an employee’s combined contributions to all 401(k) accounts for the year can equal only $15,000.
Opportunities may exist
I believe Roth 401(k)s offer some very real potential benefits, and we hope the government is expeditious in ironing out the remaining kinks. At present, however, the details of the accounts are still in their maturation process.
If your employer is offering a Roth 401(k) or if you’re an employer considering offering a Roth 401(k) option to your employees, be sure to contact your investor coach or adviser to review all your options.
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Jon Bucklin CFP, RFC is an Investor Coach and founder of Wealth Management Partners, LLC in Okemos. He has been helping investors avoid the pitfalls of investing for 24 years.