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Traditional 401(k), Roth IRA, Roth 401(k) – Oh My! April 4, 2007

Posted by pf in Expenses and Savings.
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The Roth 401(k) was created with the Economic Growth and Tax Relief Reconciliation Act of 2001, which allowed employers to begin offering these plans on Jan. 1, 2006.  However, a key point here is that they are not required to offer one.  I suspect that’s one of the reasons its expansion has been gradual. 

 Well, I recently learned that the Roth 401(k) is now available to me.  Whee!  I’ve actually been anticipating this for some time and was excited at the prospect of leveraging this new retirement vehicle.  The primary reason for my excitement is that until just a few years ago, I contributed exclusively to my 401(k) as I tried to max out my savings there.  As a result, the overwhelming majority of my retirement savings is on a pre-tax basis.  At retirement, I will have to pay taxes on both my contributions and earnings within these accounts.   Therefore, the Roth creates an opportunity for me to diversify my future distribution streams.  Of course, I have been doing it to some extent with my current Roth IRA contributions.  However, with a maximum contribution of $8000 / year (both me and my wife), it’s slow going…especially when we are still contributing to a 401(k) as well.

Like the Roth IRA, there are some great opportunities with a Roth 401(k)

  • Contributions are same as regular 401(k), currently $15,500 for 2007 or $20,500 if 50 or older.  As mentioned above, this allows much greater savings than you would with the current Roth IRA ($4000 / yr or $5000 if 50 or older)
  • After tax contributions and earnings are tax-free upon distribution after 59 1/2 and held for 5 years or more (just like the Roth IRA). 
  • New avenue for high income individuals who are currently unable to contribute to a Roth IRA due to income restrictions (no limits on Roth 401(k)s)

However, there are some limitations

  • Your overall contribution limit is fixed, whether you contribute to a Roth 401(k) or a Traditional one.  You don’t get to save “extra” – you just have another vehicle to save your maximum of $15,500 / year or $20,500 if 50 or older
  • The Roth 401(k) is subject to minimum distributions – just like your Traditional IRAs, etc.   The Roth IRA is not subject to minimum distributions
  • Any company match in your Roth 401(k) is actually done on a pre-tax basis in your regular 401(k). 

As I already struggle to contribute the maximum to both my 401(k) and a Roth IRA, the fact that I don’t get an “extra” $15,500 to potentially contribute isn’t really a roadblock for me (much as I would like to have that problem).  My real issue is that I now must “choose” how to divvy up whatever money I have to contribute….this is a difficult choice.

 If I switch all my Traditional 401(k) contributions to the Roth 401(k), I will see a haircut in my take home pay since the Roth 401(k) is made with after-tax contributions.  Further, I will no longer enjoy the reduced income and thus reduced tax bill that I now receive by contributing to my 401(k). 

Generally, from what I’ve read, the decision really depends on what you think your future tax rates will be in retirement.  Ugh…I really do not enjoy the gazing into the crystal ball aspect of financial planning.  Basically, if you think taxes will be higher, then the Roth is the preferred investment because you are paying lower taxes now (after-tax contributions) to receive more money later (no tax on the distributions in a higher tax rate environment).  If you are expecting lower tax rate, then the suggestion is to keep on plugging away at your 401(k) and get the higher tax break now and pay the lower taxes on your contributions and earning later in retirement. 

Obviously, I don’t know the answer, but I can tell you what I currently believe:

  • Current tax rates are historically low – seems they can go only one way…up
  • We are going to have to pay for our deficits in Social Security and national debt sometime (most likely via higher taxes)
  • In 2010, everyone (regardless of income) can convert their traditional IRAs to a Roth.  The conspiracy theorist in me tends to think this has been setup for the rich folks to take advantage of before the inevitable tax hikes I anticipate above

So, based upon my current beliefs (accurate or inaccurate as they may be), the choice seems simple eh?  Generally yes, if I really believe that is my future, that’s the way I should go.  However, the “present” continues to get in the way of me taking immediate action.  In particular, our family is growing and we are planning to purchase a new home that will likely much more of our financial resources.  As such, I feel a need to keep as much of my current income as possible.  By switching to the Roth 401(k), I will reduce my take home and increase my current tax burden….I’m not sure if that is the best decision for me right now.

However, with these types of things I have tended to take the long view and force myself to sacrifice a bit of the now for a better future later.  For example, even though I just said we need as much current income right now, I still just plowed $2,000 into my Roth IRA to max out my contributions for 2006 because once the window is closed for this year, it’s CLOSED and I can’t go back and make that contribution again.  Perhaps my logic is just backwards…or it’s just a case where I want to “have my cake and eat it too” by both saving as much as I want AND having enough money to buy the house we want. 

 Unfortunately, I won’t be able to have it both ways and will have to make a choice.  Right now, my choice is to stay the course and continue to contribute to my 401(k) and Roth IRA.  However, I’m going to ponder on it some more and see if I come up with a different answer.  Ultimately, neither decision is permanent.  I can always change course at some later date (assuming they don’t yank the rug out from under when this stuff expires in 2010!).

If anyone has some strong opinions / suggestions either way, I would really like to hear them…and no, suggesting I click my heels together 3 times does not count.

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