With the new year around the corner, many workers saving for retirement are wondering whether to make changes to their strategies. One common question will be whether to put money into a Roth 401(k) plan.
A little background information. The Roth individual retirement account (IRA) was created in 1998. Instead of offering a tax break when you contribute, the Roth only allows after-tax contributions; and instead of subjecting retirement-age withdrawals to income taxes, qualified Roth IRA withdrawals are tax-free.
Unfortunately, the Roth IRA limits contributions to $5,000 for those under 50 and $6,000 for those 50 and over. In 2011, eligibility to contribute starts to phase out for single filers with adjusted gross incomes of more than $107,000 and disappears altogether at $122,000. For joint filers, the income limits are $169,000 and $179,000, respectively. Since 2010, however, all taxpayers, regardless of income level, have been able to convert from a regular IRA to a Roth IRA. This gives higher-income individuals the means to effectively contribute to a Roth IRA, although it is not as simple as a direct contribution and gets more complicated when other funds are already in a traditional IRA.
The Roth 401(k) has no income limits for contributions and offers the higher 401(k) deferral limits as well. However, not all plans offer the Roth 401(k) option.
Some of the most important features of a Roth 401(k) plan include:
- Participants are limited to the same total annual contribution amount as a regular 401(k). In 2012, you can contribute a maximum of $17,000, plus a $5,500 catch-up contribution for participants who are 50 and over, if permitted by the plan. However, your employer may set lower limits to comply with nondiscrimination rules.
- Participants can split their contributions in any way they want between a regular and a Roth 401(k) account.
- Employers’ matching contributions are based on the total of a participant's contributions to both kinds of accounts, but they must be contributed to the regular 401(k) account.
- Withdrawals from Roth 401(k) plans must be taken after age 70 1/2. However, funds in the Roth 401(k) plan can be rolled over to a Roth IRA, which would not require distributions.
Should you contribute to a Roth 401(k) if your plan offers this option? The answer might be yes if:
- You feel that you will be in a higher income tax bracket upon withdrawing funds from the plan.
- You are younger and have many years to until retirement.
- You are unsure of the direction of future income tax rates and wish to diversify the tax treatment of your retirement savings.
On the flip side, contributions are made with after-tax dollars. Anyone contemplating a Roth 401(k) contribution should look at the value of a tax deferral now vs. some unknown tax savings down the road. This is a classic time value of money analysis. Factors such as your income and age will come into play here.
Access to the Roth 401(k) feature is a plus for those participants whose retirement plans offer it. However, the decision of whether or not to contribute to a Roth 401(k) plan requires an analysis of your situation and some number crunching.
Roger Wohlner, CFP®, is a fee-only financial adviser at Asset Strategy Consultants based in Arlington Heights, Ill., where he provides advice to individual clients, retirement plan sponsors, foundations, and endowments. He recently cofounded Retirement Fiduciary Advisors to provide direct investment and retirement planning advice to 401(k) plan participants. Follow Roger on Twitter and LinkedIn. Roger also blogs at Chicago Financial Planner.