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Imagine life during your retirement years — free of work and free of kids. Now, it could be free of taxes. The Roth IRA has been around since 1997, allowing workers to invest after-tax income toward retirement. Contributions grow tax-free and are withdrawn tax-free after age 591/2. While the Roth IRA has provided an excellent vehicle for saving for retirement, its income restrictions and contribution limits have restricted its overall scope and impact.
Starting next month, workers will have an alternantive to the Roth IRA — the Roth 401(k). The Roth 401(k) is different from traditional 401(k) plans in that it will allow workers to save money for retirement after taxes have been paid, and you pay no taxes on that money when it is withdrawn in retirement. The Roth 401(k) has no income restrictions, and anyone whose employer offers the option can open one. Contributions will follow 401(k) rules, which are currently set at $15,000 in 2006, or $20,000 for those over the age of 50.
Which is better, pre-tax or post?
A 401(k) is an employer-sponsored benefit that allows an employee to have money withdrawn from his or her paycheck before taxes are taken out and put in a retirement savings plan. Employees receive an immediate tax deduction, and taxes are paid when the money is withdrawn at retirement when most people expect to be in a lower tax bracket.
With the Roth 401(k), contributions are made after taxes. As a result, the money that accumulates tax-free in the account can then be withdrawn tax-free. There is no automatic tax deduction while you are working and the tax savings in retirement can be substantial.
When trying to decide between the pre-tax 401(k) or the post-tax Roth 401(k), financial experts suggest asking yourself these two questions: What is my tax bracket now? What will it be when I retire?
“In general, this product makes sense for young, college-educated people at the beginning of their careers. They are typically in a 10% to 15% tax bracket with excellent earning potential, so that is the time to pay low taxes,” says Steve Utkus, director of the Vanguard Center for Retirement Research. Utkus also suggests that high earners and people with significant pre-tax savings take a look at this new product. “In that case, the Roth 401(k) provides the opportunity for tax diversification,” Utkus notes. “If all your retirement money is in pre-tax savings and taxes increase, you will have less money in retirement. But if some of your retirement savings are in a Roth 401(k), you will feel a whole lot better because you won’t have to pay taxes on the withdrawals.”
However, people who expect their income to be lower in retirement should stick with the traditional 401(k) for maximum tax savings. Employees have the option of contributing to both the pre-tax and post-tax versions of the 401(k) as long as the total contribution doesn’t exceed the annual limit. And if employees leave their jobs, they can roll over their investment into a Roth IRA with no penalty.