Professional Services Accounting ARTICLE -
The Grapes of Roth 401(k)s - New Retirement Vehicle May Bear Fruit For Some

Target Audience: Law Firm Professionals, Lawyers, Roth 401k Interest, Retirement, Tax Deductions

The 2001 tax law planted the seeds for an attractive new retirement planning option: the Roth 401(k) plan. Beginning in 2006, after a five-year wait, employers are finally able to offer these plans. But who should pluck one from the vine and who should move on to a different variety depends on a number of factors, and the question is irrelevant, of course, if your employer chooses not to offer a Roth 401(k).

Similarities and differences

Contributions to a Roth 401(k), like those to a Roth IRA, aren’t tax deductible. But the account grows tax free and qualified withdrawals aren’t taxed. In contrast, contributions to traditional 401(k)s (and, in some circumstances, IRAs) are tax deductible or pretax, but the account grows tax deferred and withdrawals are subject to ordinary income tax at rates currently as high as 35%.

Distribution rules for Roth 401(k)s are also similar to those for Roth IRAs. For withdrawals to qualify for tax-free treatment, they must be made after the account has been open for at least five years and after you’ve reached age 59 1/ 2, become disabled or died.

Unlike a Roth IRA, however, the Roth 401(k) doesn’t allow early withdrawals for first-time home purchases. Also, Roth 401(k)s must make mandatory distributions beginning after the owner reaches age 70 1/ 2. Some observers believe you can avoid this requirement by rolling the funds into a Roth IRA, though such rollovers aren’t expressly permitted under current tax regulations.

Big money, big potential

A Roth 401(k) may particularly appeal to high-income earners. For one thing, it provides a tax-free retirement savings vehicle to those whose eligibility to contribute to Roth IRAs is reduced or eliminated because of income limitations.

The ability for singles to contribute to Roth IRAs is phased out starting when modified adjusted gross income (MAGI) reaches $95,000 and eliminated when MAGI exceeds $110,000. For married couples filing jointly, the phaseout range is $150,000 to $160,000. Anyone can contribute to a Roth 401(k), however, regardless of income.

Roth 401(k)s also have higher contribution limits than Roth IRAs. The annual limit for a Roth 401(k) is the same as that for a traditional 401(k): $15,000 in 2006, plus an additional $5,000 “catch-up” contribution if you’re 50 or older by the end of the year. Contributions to a Roth IRA, on the other hand, are capped at only $4,000 with a $1,000 catch-up contribution, even for those not subject to phaseouts.

Keep in mind that the Roth 401(k) contribution limit is not in addition to contributions to traditional 401(k) accounts. The $15,000 limit ($20,000 if you’re 50 or older) applies to your total contributions to both plan types.

Another reason the Roth 401(k) may appeal to high-income earners is that, as we discuss further below, you’re most likely to benefit from the plan if you expect your income tax rate to be higher in retirement than it is now. And with the top tax rates at historic lows, many believe that the highest tax brackets will go up.

Not a simple decision

So which is the better choice — Roth or traditional 401(k)? Well, it’s not a simple decision, but many observers favor the Roth. Their theory is that it’s preferable to pay tax on the seeds (your contributions) than the harvest (your withdrawals).

Yet determining whether you’re better off paying the taxes now or deferring them until retirement isn’t an apples-to-apples comparison. In addition to thinking about the immediate tax consequences, you need to consider your money’s potential growth vs. inflation over time and what your tax rate may be when you retire.

And that’s no easy task — not only do you have to forecast your personal financial situation years or decades from now, but you also must attempt to foretell what will happen with the economy and the federal tax system.

More than rate of return

Of course, your potential rate of return isn’t the only factor to consider in deciding between a traditional and Roth 401(k). A traditional account may outperform a Roth depending on what happens to your tax rate between now and retirement. But a Roth 401(k) provides the peace of mind of knowing your entire account balance will be available to you in retirement tax free, regardless of any intervening tax law changes.

Say you’re 50 years old and you plan to contribute the maximum — $20,000 — to a 401(k) plan this year. If you contribute to a Roth and can afford to pay the current taxes using separate funds (so those taxes don’t factor into the equation), your $20,000 contribution to a Roth 401(k) will garner you more dollars at retirement than would a traditional 401(k), whose growth ultimately will be taxable.

This may not be a fair comparison, though. To truly analyze your benefit, consider all of the potential tax consequences for you. Some observers recommend hedging your bets by splitting contributions between a Roth and a traditional 401(k). For a line-by-line comparison of the two plan types, see the sidebar “Quinn’s Quandary: Roth vs. Traditional 401(k).”

A limited-time offer (maybe)

The Roth 401(k) option is scheduled to “sunset” at the end of 2010 along with the rest of the 2001 tax law. This means that, unless Congress changes the law, you’d no longer be able to contribute to a Roth 401(k) after that time. Still, with its allure of tax-free retirement savings, the plan is certainly worth a look.

As you can see, if tax rates remain constant, Quinn will receive the same amount of after-tax income in retirement whether he pays the tax upfront or on withdrawal. If his tax rate is lower in retirement, the traditional 401(k) is the better choice. But the Roth 401(k) wins out if Quinn’s tax rate is higher in retirement.

* Hypothetical tax rate to reflect the fact that rates could go up in the future. For 2006, the top rate is 35%.

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