 |
|
To print article, click Print on your browser's File menu. Go back |
| The Basics | |||||||||||||||||||||||||||||||||||||
| A tax-free retirement just got closer | |||||||||||||||||||||||||||||||||||||
|
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):
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:
What do the experts say? I spoke with two financial planners. Scott Jensen works at Hardy and Hardy Co. in Lima, Ohio. Scott Neal is president of D. Scott Neal, Inc. in Lexington, Ky. Both of them agree that while the tax savings from a traditional 401(k) should be invested in some way, it just doesnt happen, Neal said. Heres where they think a traditional 401(k) is best:
What will I do? Theoretically the Roth 401(k) becomes available on Jan 1. But the IRS has not released the final regulations regarding the Roth 401(k), and it might not do so in time for your employer to be able to ramp it up for your annual benefits enrollment. If Roth 401(k)s dont even seem to be on your companys radar, now is the time to put a bug in the ear of your benefits department. Related news and commentary on MSN Money
Down the road, if Congress makes significant changes to the tax code such as a flat tax or consumption tax, all bets are off. Whether or not to choose a Roth 401(k) might then become a moot point. I currently max out my Roth IRA and put 14% of my salary in a traditional 401(k). Early on in my research I figured that, when the Roth 401(k) became available, Id evenly split the 14% between the two 401(k) options, softening the tax hit on the full 14%. In subsequent years Id tilt more toward the Roth 401(k). After crunching the numbers, though, I want to up the ante faster, putting at least 10% into the Roth 401(k) in 2006 and hopefully eliminating contributions to my traditional 401(k) by 2007. The Scotts and I have our fingers crossed that Congress decides to extend the Roth 401(k) beyond 2010. | |||||||||||||||||||||||||||||||||||||
MSN Money's editorial goal is to provide a forum for personal finance and investment ideas. Our articles, columns, message board posts and other features should not be construed as investment advice, nor does their appearance imply an endorsement by Microsoft of any specific security or trading strategy. An investor's best course of action must be based on individual circumstances.