Too Much Income for a Roth IRA: Starting in January 2006 There is Another Alternative

Roth 401(K) will be available in 2006, allowing individual to designate all or a portion of their 401(k) contribution into a Roth. This option will also be available to 403(b) participants. Prior to this law change, contributions to a 401(k) were tax deductible when made and taxable when withdrawn.

For example, an individual making $100,000 a year could defer 10% into a 401(k) and only pay tax on $90,000. The $10,000 would be deposit into a 401(k) account and the $10,000 and earnings on it and any employer match would be taxable when withdrawn.

Starting on January 1, 2006, if an individual chose to put the 10% into a Roth 401(k), the entire $100,000 would be taxable, but there would be no tax on the deposit or the earnings when withdrawn (as long as you're at least 59 1/2 and have held the account for at least five years). The employer match would still go into a traditional 401(k). An individual can chose what portion of the 401(k) money can go into the traditional 401(k) and a Roth IRA.

The maximum contribution for 2006 will be $15,000 for those under 50 and $20,000 for those 50 and over.

What plan is better? A number of factors will need to be reviewed including the tax rate now versus retirement and current cash flow needs.

An individual who is using some of the tax savings to help fund the 401(k) might avoid the Roth 401(k). After the deposit is made, the money will grow at the same rate but the 401(k) will be worth less since it will be taxed on withdrawal. One also needs to consider the tax rates. For someone who is in a very high tax bracket now but does not anticipate being in a high one at retirement the traditional 401(k) makes sense. If the opposite occurs, the Roth 401(k) will be more advantageous. You should also consider where you expect future tax rates to be.

One last planning point for an estate tax point of view. A Roth 401(k) can be rolled over into a Roth IRA, which do not have to be withdrawn at age 70 ½ unlike there traditional counterparts. Therefore, the funds can remain untouched as passed down to a younger generation as a legacy.

If the employer wants to include the Roth 401(k) in its plan options, the implementation must start by October 1. Also, under the current law the plan will disappear after 2010 unless extended by Congress.

Back to Tax and Business Update Summaries

To contact Feeley & Driscoll, please click here or call us at 1 (800) 392-6192.