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| The Basics | A tax-free retirement just got closer
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Congress has changed the rules with the new Roth 401(k), letting you sock away thousands more each year to grow tax-free. The catch? Your paycheck takes a bigger hit today.
By Tracy Harger
Some people work to live. I work to retire. Im a fan of anything thats going to help me reach that goal faster.
Since I started investing 20 years ago, the two best paths to early retirement have been the 401(k) and the Roth IRA. A 401(k) lets you defer paying taxes on your savings until you withdraw the money in retirement, when your income tax rate is likely to be lower. If you think youll be in a higher income bracket when you retire, or if you want to pass money to your heirs tax-free, you might choose a Roth IRA as well, paying the taxes now so that you can reap the gains tax-free in your golden years.
We optimists who believe well be richer in retirement love the Roth IRA. I contribute the maximum amount every year.
The problem? Some people make too much money to use a Roth IRA. Benefits phase out quickly for single people with incomes more than $95,000 and married couples with incomes more than $150,000. In any case, the limit on contributions is just $4,000 for 2005 ($4,500 if you're over 50 and "catching up").
But a compelling new hybrid kicks in for 2006. The new Roth 401(k) allows savers to contribute right up to the 401(k) limit of $15,000, regardless of their current income. Those older than 50 can contribute an additional $5,000. And once they retire or reach 59 1/2, they wont owe a cent in taxes on their contributions or the accumulated gains. Thats a powerful weapon in your retirement arsenal.
Here are the highlights of the new Roth 401(k):
- Contributions are made through payroll deductions, just as in normal 401(k)s.
- But contributions do not reduce your taxable income.
- Like traditional 401(k)s, redemptions from the account can start at 59 , or after retirement, which ever comes later.
- Required minimum distributions begin at 70 1/2, unless the money is rolled into a Roth IRA, which doesnt require minimum distributions and can pass to heirs.
- Any matching employer contributions are funneled into a traditional 401(k).
- You can split your contributions between traditional and Roth 401(k) accounts.
- But you cant move money between the different 401(k) types.
- Your employer decides which investment options are available to you (unlike a Roth IRA, in which you pick whatever you like).
- The Roth 401(k) will sunset after 2010 unless extended by Congress, with no new contributions allowed.
Do the math
The biggest negative is that choosing a Roth 401(k) would reduce your take-home pay. Some simple examples (that dont account for state and local taxes or mortgage deductions) spell out the impact.
A 40-year-old making $50,000 a year falls into the 25% federal income tax bracket. He contributes 10% of his salary, or $5,000, to a traditional 401(k). This 401(k) contribution reduces his taxable income to $45,000. In the 25% tax bracket, this amounts to $11,250.
If that same person were to choose a Roth 401(k) instead, the 25% tax would be levied on the full $50,000 and the tax would be $12,500, an increase of $1,250.
The difference would be even greater for those with higher salaries. Suppose a single filer making $90,000 a year contributed the maximum, $15,000, to a traditional 401(k). In the 28% bracket, her tax would be $21,000. But that same $15,000 contributed to a Roth 401(k) would leave her with a bill of $25,200, a difference of $4,200.
Play with your future
Why on earth, then, would you choose a Roth 401(k)?
Running the numbers might convince you. Take a look at the calculator to the right to help you get a handle on the general differences between the two 401(k)s.
For simplicity's sake, Im assuming that Congress will extend the life of the Roth 401(k) beyond the initial five years. Before you take it for a test drive, remember that its a basic calculator and certain keep-it-simple assumptions have been made:
- Like that youre in a dead-end job and will never get a raise. But hey, you wont get laid off, either.
- Despite widespread advice urging you to periodically increase your 401(k) withholding percentage, you will not do so.
- The length of your retirement will be 20 years.
- It doesnt factor in any matching dollars from your employer. Remember that matching dollars automatically go to the traditional 401(k), meaning theyre taxable when you withdraw them in retirement.
- In real life, you can split your 401(k) contribution between traditional and Roth. In this calculator, its all one or the other.
However, some of the assumptions can be adjusted to your circumstances:
- Your current age, salary and tax bracket (if youre not sure of your tax bracket, see the table below).
| 2006 tax rates | | Joint return | Single taxpayer | Rate | | $0-$15,100 | $0-7,550 | 10% | | 15,101-61,300 | 7,551-30,650 | 15% | | 61,301-123,700 | 30,651-74,200 | 25% | | 123,701-188,450 | 74,201-154,800 | 28% | | 188,451-336,550 | 154,801-336,550 | 33% | | 336,551 and up | 336,551 and up | 35% |
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- The age at which you plan to retire.
- The percentage you contribute to your 401(k). Although it doesnt factor in any salary increases, you can test countless scenarios.
- Expected return on investments, both while youre working and after you retire.
- The tax bracket you think youll be in when you retire.
The first two sets of results from the financial calculator are pretty self-explanatory. But theres a third scenario that pays off best for most people: Choose a traditional 401(k) and invest the tax dollars you save. It assumes tax savings will be invested in a regular, taxable account.
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