Saturday, January 6, 2007

THE ROTH 401(k) DILEMMA

As I had predicted, now that the ROTH 401(k) has been made permanent more and more employers are offering this option to their employees [see my posting on the ROTH 401(k)]. Several friends and clients have already contacted me about this new option.

The individuals who have contacted me, all in their 50s, are in the 25% and 28% federal tax brackets and work in New Jersey or New York, which have high state income taxes and, like “Sam”, treat 401(k) contributions as “pre-tax”. This means that 30-35% of the money they have been contributing to a traditional 401(k) has been paid for by their “uncles”. With the maximum 2007 contribution at $20,500 this means that electing to put all their money in a ROTH 401(k) will cost between $6,000 and $7,000+ in tax savings. This is a substantial amount of money – an amount that most cannot necessarily afford or want to give up in exchange for future tax savings.

Due to their age they have already built up a sizeable balance in their traditional 401(k) accounts – such that the Required Minimum Distribution they will be withdrawing at age 70½ will be most likely be more than enough to cover their retirement living expenses.

As I have pointed out to those who have contacted me, the main reasons for a person in their situation contributing to a ROTH 401(k) are:

(1) to reduce your required minimum distributions at age 70 ½, and, perhaps more important,

(2) to pass your ROTH monies on to your beneficiaries tax free.

Younger employees just starting out, or who have only been contributing to a traditional 401(k) for a couple of years or have been contributing only a small amount each year, should certainly take advantage of the ROTH 401(k) option if offered. Assuming Congress does not muck up the ROTH down the road, they will reap huge benefits when they retire.

Older employees, like those whom I have described above, may want to put a small portion of their maximum contribution, say $1000 or $2000, into a ROTH account and put the rest in the traditional account.

Here’s an idea. If 2007 is the year in which you will turn 50 and you intend to contribute the full $15,500.00 “normal” amount and, for the first time, the $5,000.00 additional “catch-up” amount to your 401(k) - put $15,500.00 in the traditional account and $5,000.00 in a ROTH account.

Any questions?

TTFN

2 comments:

mcgffey said...

Nice informative post. Thanks!

I have a question for you - I'm about 30, making $40K a year in non-profit work. I'm engaged and I don't own a house, but I'm saving for a down payment. I have almost $10K in an old 403(b) from a previous job, and about 10K in student loans (and rising, since I'm a part time student)

My employer doesn't offer the ROTH 401(k), just a regular 403(c). My employer doesn't have a match - they just deposit an amount equal to 3% of my salary whether I make contributions or not.

I have begun depositing about 10% of each paycheck into the current 403(c), but I'm wondering what I should do with my old 403(c) account. Should I roll it into a ROTH IRA? A traditional IRA? Should I max out an IRA, and then add whatever's left over to the 403(c)? I've read about the various accounts, but I haven't really understood their subtleties and which would be more appropriate for my situation.

I'm wondering how to maximize the return on my savings so I'll be in the best position for retirement. Since I work mainly in the non-profit world, my salary will probably never be too high, so I really need to save effectively.

Any advice on what to do with my old 403(c) and current retirement contributions? Thanks! Love your site!

Robert D Flach said...

Mcgffey:

Glad you enjoy the blog!

Sorry for the delay in responding. As the tax filing season is fast approaching I have been very busy getting ready for the deluge that will begin on February 1st.

I do not provide financial advice, to clients or readers. The most I can do is to explain the tax consequences of the various options available in a given situation.

As it is almost tax time I really do not have the time to provide you with a detailed analysis of the various options available to you.

My quick response is that you might consider rolling the $10,000.00 in the old 403(b) into a traditional IRA. This can be done tax free. As you are planning to purchase a personal residence in the near future, you will be able to withdraw up to $10,000 from an IRA to purchase a home without having to pay the 10% premature withdrawal penalty. The withdrawal will be subject to regular federal and state income tax, but if the home is purchased early enough in the year the deductions for mortgage interest and real estate taxes (and possibly points) should help to reduce the additional tax on the withdrawal.

You will not be able to rollover monies from a 403(b) directly to a ROTH IRA until tax year 2008.

Perhaps after the tax season is over I will post a discussion of the differences in the various retirement savings options.

I hope I have been of some help.

RDF
The Wandering Tax Pro