A New Option for Your 401k 2/4/07
Stewart H. Welch III, CFP, AEP
Founder, The Welch Group, LLC
A New Option for Your 401k
“A New Option for Your 401(k)”
Last week, I discussed how business owners who employ few or no employees still have time to receive a large tax benefit for 2006. This week I’ll discuss a new retirement plan option that many employers will make available through traditional 401(k) and 403(b) retirement plans. The Pension Protection Act of 2006 made permanent the provisions allowing employers to offer Roth IRA style investing through their 401(k) plan. A key difference between the regular Roth IRA and the Roth 401(k) is the amount you are allowed to contribute. A regular Roth IRA allows contributions of up to $4,000 for 2007 plus an additional $1,000 if you are age 50 or older. In addition, your ability to contribute to a regular Roth IRA is phased out for couples with modified adjusted gross income (AGI) of $150,000-$160,000 ($95,000-$110,000 for single filers). With a Roth 401(k) no such income limitations apply and you may contribute up to $15,500 plus an additional $5,000 if you are age 50 or older. As with a regular Roth IRA, you don’t receive a tax deduction for your contribution but your money grows tax deferred and withdrawals during retirement are tax free.
You probably think that you should be making pre-tax contributions for your retirement plan but wonder whether contributing to a Roth IRA makes sense. The answer is that it may. Let’s begin with a couple of rules of thumb. If your marginal tax bracket is 25% or less, the Roth 401(k) may make sense since the immediate tax deduction is not as valuable to you. On the other hand, if your marginal tax bracket is 33% or higher, it tends to favor the tax deductible 401(k) contribution. Those in the 28% marginal tax bracket might consider it a ‘push’…either choice may turn out to be the best choice. Income tax rates are, and have been, at multi-year lows. If you believe income tax rates are likely to be significantly higher when you retire, you should give strong consideration to the Roth 401(k).
Perhaps the best strategy is a ‘hedging’ strategy where you make part or all of your 401(k) contributions into the Roth knowing that any employer contributions will be made in the traditional 401(k). At retirement, this will give you at least two pools of money, one that is subject to taxes upon withdrawal and one that is not. This will allow you maximum flexibility in controlling your post retirement income tax planning. For example, you may choose to tap your Roth first in order to avoid or minimize taxes on your Social Security income.
One final note. Investing in a Roth 401(k) will result in a richer retirement account balance since you paid the income tax on the annual deferrals each year. So if two individuals both invested $15,500 each year in the exact same investment for the same number of years, the one who invested in the Roth 401(k) would, in effect, have more money since any withdrawals are tax-free.
Due to the complexities inherit in this decision, I recommend that you visit with your financial or tax advisor before making your decision.