Roth 401(k) concept useful for high wage earners
MARK S. MARTEL
The Roth IRA has been a hit with a lot of investors and financial advisors since its creation as part of the Tax Relief Act of 1997. A Roth IRA contribution is not deductible up front, but investment gains accrue tax-free inside the account, and withdrawals taken in retirement are tax-free under current law. Roth IRA assets also pass to one’s heirs without being subject to income taxes. This has particular appeal for folks who can’t deduct contributions to a traditional Individual Retirement Account.
More recent tax legislation made it possible for employer-sponsored 401(k) plans to offer the option of Roth-style accounts for employee contributions, starting in 2006. Just like with a Roth IRA, those elective contributions to a Roth 401(k) account would come from your after-tax pay (no up-front deduction). If your employer offers to match your contributions to some extent, the matching dollars are still considered pre-tax (not currently taxable to you) and would be made into a separate, traditional 401(k) account.
Again, the big attraction is the prospect of withdrawing future retirement income tax-free from the Roth 401(k).
That assumes the withdrawals are made after you turn 59-1/2 and your contributions have been invested for five years or longer. If you already are contributing the maximum to your 401(k) plan, but you earn too much to contribute to a personal Roth IRA, you might find the 401(k) concept an attractive complement or alternative. But there are a number of factors to bear in mind. For example, even if your 401(k) plan adds the Roth account option, the combined limit on your elective contribution remains the same: $15,000 in 2006, or $20,000 if you are over 50 years old. So, contributing to a Roth 401(k) account does reduce the amount you could contribute on an up-front deductible basis.
It’s very difficult to determine for sure whether an up-front deduction or future tax-free withdrawals will prove more valuable to you. You have to make a run of assumptions about marginal income tax rates years into the future, investment returns over time, the relative likelihood of other tax law changes, and your own financial prospects. At a fundamental level, most 401(k) participants are not coming close to maxing their contributions, which suggests that the greater challenge is trying to find room in the monthly budget to direct a few more dollars toward retirement savings. By capturing the deduction up front, the traditional 401(k) contribution approach makes that inherently more affordable.
Nevertheless, if you find that setting the money aside is easy, and your big concern is reducing income taxes after you retire (and perhaps for your heirs), the Roth 401(k) may be just your cup of tea. If your 401(k) plan introduces a Roth account alternative, your financial and tax advisors can help you set a strategy. And since hardly any issue is absolutely black and white, maybe you’ll decide to max your traditional (deductible) 401(k) contribution, then use those tax savings for a Roth IRA contribution.
Mark S. Martel, certified financial planner and partner with First Pacific Associates/KMS Financial Services Inc., has provided investment and retirement planning to the community of Vancouver and surrounding areas for twenty-four years. He can be reached at 360-254-2585.