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Roth 401(k): a new way to grow money tax-free

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Roth 401(k): a new way to grow money tax-free

By Laura Bruce • Bankrate.com

Pretax or after-tax? That is the question many employees will face starting Jan. 1, 2006, when the government allows companies to offer a Roth 401(k).

The Roth 401(k) will give employees the option of setting aside money from their paychecks that's already been taxed and saving it in a retirement account where it can grow tax-free forever. A Roth 403(B) will be available to 403(B) plan participants.

If you have a regular 401(k) or a regular Roth IRA, you'll still be able to contribute to both of those accounts; the Roth 401(k) is simply another option.

The Roth 401(k) is similar to the Roth IRA in that after-tax money is being saved and grows tax-free, but, as its name implies, the new account will fall under 401(k) rules. Those rules, as they pertain to the new account, are still in the "proposed" stage. The IRS may tweak them in the months to come, but here are some of the main features of how the Roth 401(k), as it stands now, will work.

● Employees will be able to contribute after-tax dollars to the Roth 401(k). The money will be held in a separate account from contributions to your regular 401(k). You decide what percentage of your retirement plan contributions go to either account.

● You'll be able to make the maximum contribution allowable under 401(k) rules. The 2006 401(k) contribution limits allow employees less than age 50 to sock away up to $15,000 -- $20,000 for employees age 50 or older. For those who want to save after-tax money, this is a much quicker route than saving in the Roth IRA, which has contribution limits of $4,000 for those less than age 50 and $5,000 for those age 50 and above in 2006. If you have a Roth IRA, or plan to open one, you can still contribute the maximum allowable to that account in addition to your Roth 401(k) contributions.

● If your company provides a matching contribution, it will be pretax money and will go only into the regular 401(k) account.

● The Roth 401(k) is open to all employees who qualify for the regular 401(k). This is a boon to higher-paid employees who may be excluded from having a Roth IRA account because of its income limitations.

● Contributions are irrevocable. Once the money goes into the account, it falls under all of the IRS rules and penalties for 401(k) accounts; you can't change your mind and have it switched over to your regular 401(k).

● Money can be withdrawn tax- and penalty-free as long as you're at least age 59½ and have held the account for at least five years.

● The Roth 401(k) has the same distribution requirements as the 401(k). You'll need to begin taking minimum distributions by the time you reach age 70½. This contrasts with the Roth IRA, which has no distribution requirements.

● You can roll over your Roth 401(k) contributions to a Roth IRA when you retire or if your employment is terminated.

That rollover feature seems to offer an easy way around the distribution requirements if you're planning to leave the account to an heir or if you simply don't want to withdraw money from the Roth by age 70½.

But, for most people, the main reason to contribute to a Roth is to let the money grow tax-free. No one knows what the tax rates will be in the future, so it seems wise to hedge the taxable contributions and earnings in a 401(k) with earnings in a Roth that can be withdrawn tax-free. This is especially true if you're young and in a low tax bracket but have every reason to believe your income will be increasing, putting you in a higher tax bracket.

Tom Grzymala, a certified financial planner with Forensic Analytics in Keswick, Va., advises contributing to the regular 401(k) up to the amount that's being matched by the employer or you'll be leaving money on the table. After that, put your money into the Roth 401(k).

"Would you rather enjoy a $1,680 tax break today on your $6,000 401(k) contribution while you're in the 28-percent tax bracket, and then pay taxes on the $6,000 plus all the dividends and appreciation that might accrue over the next X years? Or, would you rather pay the $1,680 in taxes today, and, X years from now, take out the whole enchilada for free? It doesn't seem hard to figure that one, especially if you're a 30-something!"

As Grzymala notes, the benefit of tax-free savings is a no-brainer for younger workers who have 20, 30 or 40 years before retirement, but people who are close to retirement should carefully weigh the options.

Geordie Crossan, CFP, and president of NBS Financial Services in Westlake Village, Calif., advises employees to look at all of the sources they'll be using for money at retirement.

"Is it in qualified retirement plans or is it outside of qualified plans -- stock options, brokerage accounts? If their assets aren't in (tax-deferred) qualified retirement plans, then any ability to save in a tax-free vehicle vs. money coming out fully taxable gives options for planning distributions."

A survey by Hewitt Associates indicates that approximately 33 percent of 401(k)-plan sponsors are likely or somewhat likely to offer the Roth 401(k).

Lori Lucas, director of participant research at Hewitt, says it may take a show of interest by employees to get companies to add the Roth 401(k) option to their plans.

"We did the survey late last year, quite a ways off from when the Roth 401(k) would be available. There's some ambivalence on the part of plan sponsors. They're weighing trade-offs. The Roth 401(k) adds flexibility to the typical 401(k) plan, but it could add a dimension of confusion. People will need more education and more tools to understand the difference (between the regular 401(k) and the Roth 401(k).)"

Another reason some companies may be skittish about adding the Roth 401(k) is because it comes under a tax act that expires at the end of 2010. Unless Congress extends the act, participants will not be able to contribute additional money to the Roth after that time, although money already in the account would continue to grow tax-free.

But, as Crossan points out, from a saver's standpoint, if it makes sense to do something, then it makes sense to do it even if it's just for four years.

If you're interested in contributing to a Roth 401(k) plan, it may be in your best interest to talk to your employer about it. Don't assume the company will automatically make the arrangements.

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