Understanding the New Roth 401(k)

There are plenty of ways to save for retirement. And come January 2006, some employees will be faced with evaluating and deciding whether to use a new tax-sheltered way of investing for retirement - the Roth 401(k).

The new option combines some of the best features of Roth IRAs and traditional 401(k) plans.

Roth IRAs enable individuals to (1) invest after-tax earned income, (2) let it grow tax-free, and (3) take tax-free withdrawals (provided certain conditions are met). Roth IRA owners do not have to take required minimum distributions (RMDs) that traditional IRA and 401(k) plan participants must take after reaching age 70½.

401(k) plans more closely resemble traditional IRAs. Participants generally (1) invest pre-tax earned income and (2) enjoy tax-deferred growth, though they must pay taxes on all distributions.

Participants in these employer plans are able to contribute significantly more than the current $4,000 ($4,500 if age 50 or older) permitted when investing in IRAs. They may contribute and deduct $15,000 in 2006 - up from this year’s $14,000 - plus an additional $5,000 - up from this year’s $4,000 - under a "catch-up provision" for age 50 or older.

Roth 401(k) features:

• Like a Roth IRA, contributions to a Roth 401(k) are made with after-tax dollars, all gains on contributions grow tax-free, and all ultimate distributions are tax-free, as long as certain conditions are met.
• Unlike a Roth IRA which has income limits for participation, a Roth 401(k) has no such limits.
• Like a 401(k), Roth 401(k) maximum annual contribution limits are high.
• Unfortunately, like a 401(k), Roth 401(k) plans do require RMDs at age 70½, but this can easily be avoided by rolling account balances over to a Roth IRA, regardless of income.
• Employees may participate in both Roth 401(k) and conventional 401(k) plans and contribute to each annually, provided that aggregate annual contributions do not exceed the 2006 $15,000 plus "catch-up" limit.

How many companies will add Roth 401(k)s to their plans? Surveys of large employers by Hewitt Associates indicate that about 30% are likely to add such accounts to their plans in January. Interested employers are waiting for the Treasury to issue final regulations so that they can complete their plan designs and ensure that payroll and recordkeeping systems are ready for the additional work.

Who should consider using a Roth 401(k)?

• Those who want to avoid RMDs after age 70½
• Those who predict that using the Roth will produce tax savings after factoring current and future income and tax rates. In essence, participants who expect their tax rates to be at least as high during retirement.
• Maximum savers, mostly earning high income or having high net worth, who will be contributing at/near the maximum limit. By keeping the maximum limits the same for the new Roth plan as for the existing pre-tax plan, Congress has effectively increased the savings that individuals can shelter from taxes in their retirement plans.
• Participants who usually max out Roth IRA contributions or who are prevented (by the income limit) from even making Roth IRA contributions. The new option increases accessibility to a Roth-type savings vehicle.
• Younger workers who have several years to take advantage of long-term, tax-free growth

Who should consider staying with a traditional 401(k)? Older employees who may be in peak earning years and expect to be in a lower tax bracket during retirement might consider using the traditional 401(k), which allows them to defer taxes at high rates now and pay them at lower rates in the future.

These broad categories notwithstanding, 401(k) participants offered the opportunity to consider a Roth 401(k) should consult with a trusted financial planner. Each person’s situation is different, and the traditional 401(k) vs. Roth 401(k) choice needs to be made within the context of an individual’s overall financial picture and goals. The appropriate choice has long-term financial implications and needs to be made in a thoughtful manner.

James Terwilliger, Certified Financial Planner™, is Vice President, Financial Planning, Wealth Strategies Group, Canandaigua National Bank & Trust Company. He can be reached at 585-419-0670 ext 50630 or by email at jterwilliger@cnbank.com.