A New Way to Generate Money and Never Pay Taxes On It
5/06
Starting in January, 2006, the Roth 401(k) plan became available to employers to offer to their employees. This new type of retirement account can be described as a cross between a traditional 401(k) plan and a Roth IRA in that it combines features from each of these existing types of retirement accounts.
Unlike traditional 401(k) contributions which are made with pre-tax dollars, contributions to a Roth 401(k) will be made with after-tax dollars. On its face this may seem contrary to logic; however, over time, there can be a substantial difference in how much money ends up in your pocket. In a traditional 401(k) plan, your current income taxes are reduced because income taxes are deferred on money contributed to the plan. Unfortunately, you will pay income taxes when you make withdrawals during your retirement years. With the new Roth 401(k) you will pay income taxes upfront and the money you contribute to the plan but the withdrawals you make in your retirement years will be tax free.
The traditional 401(k) plan, the new Roth 401(k) and the Roth IRA all provide you with tax-deferred earnings. This means that, once money is placed in any of these types of accounts, it will grow tax free. Participation in any one of these types of plans is a good idea. Finding the best plan for your circumstances will probably require consultation with your financial planner.
The nice thing about the new Roth 401(k) is that every employee that works for a company that implements this plan will be eligible regardless of income level. The Roth 401(k) does not have the income limitations ($110,000.00 for an individual or $160,000.00 for a married couple) that restrict investments in Roth IRAs.
The Roth 401(k) fits particularly well with a highly paid workforce that will be in a high tax bracket after retirement. If you are someone who believes that are tax rates will increase in the future in order to pay for a large national deficit, the Roth 401(k) would make sense because you would be paying taxes now at the lower rates than when you eventually withdraw your funds. The Roth 401(k) also makes sense for young workers who are just starting their careers and who are in a lower tax bracket now than they will be when they ultimately retire.
To illustrate the benefits of a Roth 401(k), consider the employee who contributes $10,000.00 a year to a traditional 401(k) plan. No tax is paid on the $10,000.00 contribution; however, when the account grows to say, $300,000.00 and required minimum distributions must be taken, the income tax on the distribution amount can be far greater than what one would pay now. Compare that with the individual who will currently pay a couple of thousand dollars in income tax to invest in a Roth 401(k). When that individual’s account reaches say, $300,000.00, all income taxes will have already been paid and that individual will have the full $300,000.00 available during retirement. The longer the holding period, the more the Roth 401(k) will outperform the traditional 401(k) due to tax-free compounding. In terms of the after-tax value of your investment, you will almost always come out ahead with the Roth 401(k). An added benefit to the Roth 401(k) is that it can be rolled over to a Roth IRA where, unlike traditional IRAs and 401(k)s, the minimum distribution rules do not apply.