Plans offer retirement savings choices

Kevin Price
Kevin Price

Traditional and Roth 401(k) plans both offer tax-advantaged ways to save for retirement. Which works best for you depends on your unique circumstances.

Many employees now have — or soon could have — a new retirement planning option to consider: the Roth 401(k), which permits participants to save for retirement on an after-tax basis. In return for forgoing a tax deduction at the time of contributions, participants may make withdrawals free of taxes and penalties if they’re age 59 1/2 years or older and have maintained the account for five years or more. This feature could appeal to investors who anticipate being in a higher tax bracket in retirement.

Contribution limits for the 2015 tax year are identical to those for a traditional 401(k): an annual maximum of $18,000 plus an additional “catch-up” contribution of $6,000 for workers aged 50 or older. Once contributions are made to a Roth 401(k), they can’t be transferred to a traditional 401(k). Assets in a traditional 401(k) likewise can’t be transferred to a Roth 401(k).

The Roth 401(k) could appeal to workers willing to forego a tax break now to get one at retirement. As its name implies, the Roth 401(k) combines features of a traditional 401(k) with those of a Roth IRA. Like a traditional 401(k), workers enjoy the convenience of contributing through payroll deduction. But similar to a Roth IRA, contributions are made on an after-tax basis and withdrawals after age 59 1/2 are tax free and penalty free for workers who’ve maintained their account for five years. There’s also a Roth 403(b) plan for workers in the nonprofit sector.

The Roth 401(k) follows many of the same rules as a traditional 401(k). For the 2015 tax year, federal laws permit a maximum annual contribution of $18,000, although your employer could impose a lower limit. Your employer could provide a matching contribution as part of a Roth 401(k), but any matching contributions are made in pre-tax dollars. If you’re age 50 or older, you may contribute an additional $6,000 for a total of $24,000 in 2015.

You may continue to maintain a traditional 401(k) while directing all or a portion of new contributions to a Roth 401(k). Your contributions to a Roth 401(k), however, are irrevocable — once made, they can’t be transferred to a traditional 401(k) account, and funds in a traditional 401(k) can’t be switched to a Roth 401(k). Both Roth and traditional 401(k)s require distributions after age 70 1/2, but only if you’re no longer working. If you continue to work beyond age 70 1/2, you won’t be required to take distributions from either type of account. Distributions must begin, though, when you finally leave the workforce.

A Roth 401(k) could offer a significant benefit when it’s time for retirement — the funds can be rolled over directly to a Roth IRA with no tax payment. Assets in a traditional 401(k) can also be converted to a Roth IRA, but the conversion requires you to pay taxes on the portion of the rollover that hasn’t yet been taxed.

If you’re considering a Roth 401(k), you might want to review the following points before making your decision:

Although future tax rates are difficult to predict, you could benefit from a Roth 401(k) or 403(b) if you anticipate being in a higher tax bracket during retirement.

Even if your marginal tax rate remains relatively stable, you could face a higher tax bill in retirement if you no longer claim deductions for dependents, mortgage interest and other types of deductions frequently used by families. If this sounds like a likely scenario, a Roth 401(k) could be to your advantage.

Will you need your retirement assets for living expenses during your later years? If not, a Roth 401(k) offers the opportunity to roll over funds directly to a Roth IRA, which doesn’t require distributions after age 70 1/2. This situation could enhance the potential tax-free growth of your assets and enable you to bequeath a larger portion of your assets to your heirs.

While individuals at any income level may contribute to a traditional IRA, the deductibility of contributions may be limited, depending if they participate in a qualified employer-sponsored retirement plan. Roth IRAs are limited to single taxpayers with income under $131,000 and married couples with income under $193,000 in 2015. A Roth 401(k) could have some appeal if you desire tax-free withdrawals, but your income exceeds the threshold for a Roth IRA.

The longer you remain invested in a Roth 401(k), the more you’re likely to benefit from tax-free growth. If you plan to retire in five years or less, a shorter-term time horizon could limit the benefit of tax-free withdrawals, whereas your account could get a bigger boost from tax-free savings if you plan to continue working for a longer period of time.

Capitalizing on every option available to you could make it easier to pursue your long-term savings goals. If tax-free withdrawals could potentially benefit you and your employer makes a Roth 401(k) available, consider adding it to your retirement planning mix.

In review, here are some points to remember:

A Roth 401(k) offers the option of investing for retirement on an after-tax basis. In return for foregoing a tax deduction when the contribution is made, participants may be able to make withdrawals free of penalties and income taxes during retirement.

Workers may elect to make all or a portion of their 401(k) contribution to a Roth 401(k). Once made, however, a contribution can’t be transferred to a traditional 401(k), and assets in a traditional 401(k) can’t be switched to a Roth 401(k).

The annual maximum contribution for 2015 is the same as for a traditional 401(k): $18,000 plus an additional $6,000 catch-up contribution for employees aged 50 and older.

Employers who provide a matching contribution are required to allocate the match to a traditional 401(k), not a Roth account.

Either Roth or traditional 401(k) balances may be rolled directly over to an IRA or another eligible retirement plan, although taxes could apply and the rollover rules can be complex. See your financial advisor prior to requesting a rollover.