Traditionally, your 401(k) contributions have been pre-tax, meaning they reduce your taxable income dollar-for-dollar the year you make the contribution, the money grows tax-deferred and you pay income taxes on it when you retire.
But this year, some employers will start offering workers an opportunity to contribute after-tax money into their 401(k)s that will grow tax-free. The new option is called a Roth 401(k) -- or a Roth 403(b) if you work for a non-profit. It's not a separate plan from your existing 401(k), but rather a new element to it.
If your company offers one, you will be asked first how much of your gross income you'd like to contribute to your 401(k) -- say, 15 percent. And then of that, you'll indicate how much you'd like to put in the pre-tax portion of the plan and the after-tax portion – say, 7.5 percent in each.
There are three key advantages to a Roth 401(k):
1) You can use one even if your income is too high to qualify you for a regular Roth IRA.
2) You can contribute far more to a Roth 401(k) than to a regular Roth IRA, which caps your contributions at $5,000 ($6,000 if you're 50 or older). In your 401(k) – whether your contributions are made pre-tax, after-tax or some combination of the two -- you may contribute up to $15,500 for 2007 and 2008 ($20,500 if you're 50 or older).
3) Any money you contribute to the after-tax portion (the Roth 401(k)), and the earnings on those contributions may be withdrawn tax-free when you retire.
Depending on your situation, though, there are some potential drawbacks when you contribute to a Roth 401(k):
- Your taxable income will be higher, and your take-home pay will be less. Say you make $100,000 and opt to put 15 percent of your income into your 401(k), half in a pre-tax account and half in a post-tax account. Your taxable gross would be $92,500. By contrast, if you'd put it all in pre-tax, your taxable gross would be $85,000.
- You may be disqualified from other tax breaks. If your 401(k) is your only deduction and/or if your adjusted gross income would disqualify you from other tax breaks without the benefit of your 401(k) deduction, then you may lose out on other tax breaks as well. Say you're single and your AGI is just below the AGI limit at which you're disqualified from deducting student loan interest, or taking a child-tax credit. Then you get a $5,000 bonus and contribute to a Roth 401(k). This would disqualify you from the mentioned tax deductions.
- Company matches (and the returns they earn) will be treated as taxable. But it's still free money and you shouldn't pass it up. So be sure that you're contributing enough to your 401(k) -- either on a pre-tax or after-tax basis, or both combined -- to qualify for the full match. In this case, you should maximize the pre-tax contribution up to the company matching limit, and then consider any other contributions to the after-tax portion.
- Your money can grow more quickly making pre-tax contributions to a 401(k). If you contribute $10,000 pre-tax to a 401(k), the full $10,000 will compound over time. But if you make the contribution after-tax, you'll only be investing the amount left over after taxes on that $10,000.That may be a disadvantage if you think you'll be in a lower tax bracket in retirement than you are now. That's because even with the tax bite, the distributions from your pre-tax account may still exceed the amount you'd have available to you in your after-tax account.
The presence of Roth 401(k)s is far from widespread. According to a recent survey by the Profit-Sharing 401(k) Council of America, only 17 percent of 401(k) plan sponsors say they will add a Roth feature to their plans. Another 35 percent said they do not intend to. And 41 percent said they were still undecided.
That may change. The IRS has just come out with its final regulations governing Roth 401(k)s, which gives plan sponsors more certainty. And, according to the Principal Financial Well-Being Index, a high percentage of workers at companies with less than 1,000 employees have heard of Roth 401(k)s and said they would participate in the accounts if they had the option.