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Roth 401k

How the Revolutionary Roth 401k Can Offer You Tax-Free Investing and, Perhaps, a Much Wealthier Retirement

By David Fisher

(LifeWire) - Are you looking for a way to shelter retirement money tax-free, for life? For those who are lucky enough to have one, the Roth 401k provides an avenue to do just that.

Well, almost tax-free. As with its cousin, the Roth IRA, any money that goes into a Roth 401k is taxed in the year in which it is contributed. After that, though, it's smooth sailing - no taxes on the growth and no taxes on withdrawal. This can make an enormous difference over an investing lifetime, even as high as millions upon millions of more dollars available to you and your family.

Investors that manage their holdings through a Roth 401k can contribute up to the same maximum amounts that govern regular 401k accounts - $15,500 for most in 2008, with an additional $5,000 catch-up provision for anyone over 50. That compares quite favorably with the Roth IRA contribution limit of $5,000 with a $1,000 catch-up as of 2008.

What really sets the Roth 401k apart is its income cap: There isn't one. Unlike a Roth IRA, which disappeared as an option altogether in 2008 for joint filers with adjusted gross income higher than $169,000 or single filers with income higher than $116,000, the Roth 401k allows anyone to contribute, no matter the size of their annual paycheck.

The only catch is that you must work for a company that offers the option.

Background

One of a set of retirement savings options created by the Economic Growth and Tax Relief Reconciliation Act of 2001, or EGTRRA, the Roth 401k has been a long time in coming. Despite its authorization in 2001, the Roth 401k didn't take effect until Jan. 1, 2006. Despite the potential advantages it offers to many retirement savers, the Roth 401k has also been a bit slow to catch on, perhaps because people aren't aware of the enormous advantages it offers.

US Department of Labor statistics show that nearly two-thirds of employees of large and mid-sized companies are covered by retirement plans, and more than 34% of employees of small firms are covered. But a survey of 429 firms done in 2007 by the trade group Profit Sharing/401(k) Council of America showed that only 22% offered a Roth 401k, and only 8% of eligible employees made contributions to them in 2006.

The option is particularly advantageous for high-income earners who expect to maintain high income through retirement. Even though initial contributions are taxed, rather than going in pre-tax as with a traditional 401k, the fact that earnings growth is never taxed generally gives the Roth a huge boost in overall value.

The higher the tax rates in retirement, of course, the bigger the benefit of a Roth. So, whether you command a high income or not, if you are among those who are betting that tax rates will rise rather than drop or remain the same through your lifetime, a Roth 401k is worth a look - if you can get one.

How It Works

Employers can provide both a Roth 401k and a traditional 401k option for their employees. Technically, the options are part of the same 401k plan: Roth money is simply held in an account that is separate from any contributions to the traditional 401k. Employees can contribute to both in the same year, as long as they don't exceed the overall contribution limit of $15,500 (or $20,500 if they are over 50).

If your employer offers a Roth 401k option, here are some key points to keep in mind:

  • Contributions: Since Roth 401k contributions are taxed before they go into the account, contributions can be withdrawn at any time without penalty. However, participants have to wait at least five years after the account is opened before they can withdraw any gains, and participants will face a 10% penalty and income taxes on the gains if they are pulled out before the participant turns 59 1/2.
  • Withdrawals: Roth 401k participants are required to start withdrawing money from their plans at age 70 1/2. Owners of Roth IRAs face no such requirement. There's one way around this requirement: The Roth 401k can be rolled over into a Roth IRA after retirement or after the participant leaves the company.
  • Rules for employers: If an employer offers both a Roth 401k and a traditional 401k, contributions to both are considered when the company faces the complicated non-discrimination tests that weigh the relative level of contributions of highly paid and not-so-highly paid employees.
  • Social Security: Unlike withdrawals from a traditional 401k, Roth 401k withdrawals aren't considered when the IRS attempts to determine whether your Social Security benefits are taxable.
  • Permanence: The Roth 401k option was originally set to expire in 2010, but the Pension Protection Act of 2006 made it permanent.

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