ROTH 401(k)

by Doug Charney

According to the Social Security Administration and the U.S. Bureau of Labor Statistics, you will need approximately 70 percent of your current income to maintain your same standard of living when you retire. In other words, if you make $50,000 annually now, you will need approximately $35,000 in annual retirement income.

The Social Security Administration claims the average person receives about $10,000 per year from Social Security. That leaves a big gap between what you will need and what you have. Where’s the money going to come from?

Quite simply, most of your retirement income will need to come from you—from the retirement savings you build now. If you are like most people, you simply contribute to your company-run 401(k) plan. The traditional 401(k) plan and the Roth IRA are the most common retirement-savings vehicles.

As of last month, individuals are now able to open a Roth 401(k) (not to be confused with a Roth IRA). Administered by your employer, a Roth 401(k) can be offered alongside the traditional 401(k) as another vehicle for retirement saving. You now can put all your savings into your Roth 401(k), all your retirement savings into your traditional 401(k) or a portion into each. As with a Roth IRA, a Roth 401(k) allows you to invest after-tax dollars. However, the Roth 401(k) does not have an income cap (the Roth IRA has a household income cap of $150,000), so everyone is eligible to start a Roth 401(k) account.

The big difference between the Roth 401(k) and the traditional 401(k) is how and when your money is taxed. With a traditional 401(k), your money is not taxed until you start withdrawing it at retirement.

For example, if you make $45,000 next year and contribute $3,000 to your traditional 401(k), you will only be taxed on $42,000 of annual income. However, if you contribute $3,000 this year to a Roth 401(k), you still have to pay taxes on $45,000 of income— you don’t get the tax break now. When you retire you can withdraw your money from the Roth 401(k) and keep all of it because you’ve already paid taxes on it.

Like regular 401(k) plans, you can roll your investment from one Roth 401(k) to another if the new plan accepts transfers. But be aware that you cannot convert your current 401(k) to a Roth 401(k). If you want a Roth 401(k), you will have to start from a zero balance.*

All 401(k) plans are tested to ensure fairness, and the Roth 401(k) plan is no exception. Both Roth 401(k) plans and traditional ones are subjected to the same “top-heavy” testing if they are not part of a Safe Harbor 401(k). A Safe Harbor 401(k) plan permits an employer to avoid discrimination testing of the rates of employee elective deferrals and/or employer-matching contributions. Safe Harbor plans permit highly compensated employees to maximize their contributions.

For example, if the vice president of a company contributes $10,000 and the lowest-paid employees put in nothing or very little into the 401(k) plan, the administrator may have to return some of the money. Under Safe Harbor, if the employer contributes 3 percent of the employees’ pay for everyone; they aren’t subjected to “top-heavy” testing. If no Safe Harbor exists and the Roth 401(k) plan fails the ADP top-heavy test, an employee who has both pre-tax 401(k) and Roth 401(k) contributions will be able to choose from which account to take the excess money. If the excess contribution is attached to the Roth 401(k), the corrective distribution is included in the employee’s gross income, but the original deposit will not be taxed because the money was taxed before it was deposited.

Whether a Roth 401(k) is a good plan for you depends on several factors. If you are a 23-year-old employee just starting out in the workforce, a Roth 401(k) makes sense because you have a long period of time to let your money grow before you retire. Even if you could contribute for only five or six years, you may still have a decent amount of money that will come out tax-free at retirement. Your Roth 401(k) could become quite large, and you would be able to take all the money out without having to pay taxes at a time in your life when you may need the money the most.

If you are 55 years old and already have accumulated a large sum of money in your traditional 401(k), the Roth 401(k) would benefit you because you would not be forced to do the mandatory withdrawal at age 70.5.Your money could continue to grow tax-free until you withdraw it—even if you don’t do it until age 95 or older.

If you are a high-wage earner who will still be in a high-income tax bracket at retirement, you could put part of your money into a Roth 401(k). When you retire, you can supplement from your Roth to keep your income lower at retirement. Still, you’ll be better off not opening a Roth 401(k) until you’ve maxed out the amount you contribute to your traditional 401(k). Right now, the tax deductible 401(k) contributions are one of the best tax-reducing tools available, so it makes sense to invest as much money into it as possible to save on your taxes now.

Think of the Roth 401(k) as a great new tool in your investment retirement toolbox. You may decide never to use it, but it’s available. If you’re still uncertain whether opening a Roth 401(k) is a wise choice for you, schedule an appointment with your financial adviser and your CPA to see how best to use this new tool, if at all. No matter which retirement savings tool you use, make sure you are using it appropriately. Review what you are contributing and consider increasing the percentage of income you invest. Don’t wait until it’s too late to start saving more for retirement. You’ll want to enjoy your retirement years, not wonder how you’ll pay your utility bills. Now is a good time to review your retirement savings plan and determine whether a Roth 401(k) makes sense for you.