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This chapter is from the book

Roth 401(k)

The Roth IRA, the relatively new kid on the IRA block because it was introduced in 1998 as a way of saving for a tax-free retirement, now has a new little brother, the Roth 401(k).

In a conventional 401(k) retirement account, a worker contributes some of his or her salary into a tax-deferred retirement account. Any money that is contributed is not subject to income tax when it is put into the account. Instead, the income taxes become due when money is withdrawn from the account. Beginning in 2006, employers can offer a Roth 401(k) that allows employees to put all or some of their 401(k) contributions into a Roth 401(k) account. The amount of the worker's salary that is contributed into the Roth 401(k) is considered as taxable wages in the year in which it is contributed to the Roth 401(k). Once in the account, however, the money grows tax-free and can be withdrawn later without incurring further income tax.

As with the regular 401(k), in 2006 as much as $15,000 can be contributed annually to an employee's Roth 401k account unless the employee is at least 50 years old; in that case, the amount increases to $20,000.

Important Loophole

In 2006, to qualify for a Roth IRA, the adjusted gross income (AGI) of unmarried individuals cannot exceed $110,000, and the adjusted gross income of married taxpayers filing jointly cannot exceed $160,000. However, unlike the regular Roth IRA that is described in detail in my book A Guide to Elder Planning (Pearson Education, 2003), there are no income eligibility limitations to qualify for a Roth 401(k).

All or Nothing at All

Besides being the title to a 1939 no. 1 hit by Frank Sinatra, this phrase also refers to the flexibility for workers whose employers offer Roth 401(k) accounts. When both types of 401(k) accounts are offered, the employees get to decide how much, if any, they want to contribute to either type of 401(k) account. For example, a worker over the age of 50 might choose to put $10,000 into a regular 401(k) account so that the amount would not be subject to current income taxes; he then might contribute another $10,000 to his Roth 401(k) account for future tax-free growth, and pay the income tax on that amount of compensation.

The Match Game

Many baby boomers fondly remember The Match Game, a daytime quiz show hosted by Gene Rayburn with the familiar voice of Johnny Olson as announcer. Baby boomers are even more fond of the matching employer contributions to their 401(k) accounts. These matching contributions are income-tax-free contributions that employers make to the 401(k) accounts of their employees. Thus, they constitute not just an incentive for employees to contribute to their 401(k) accounts, but they truly can be considered money for nothing. (However, unlike the 1985 song "Money for Nothing" by Dire Straits, you do not get chicks for free.) It is important to note that employer-matching 401(k) contributions may be made only to a regular 401(k). Employer-matching contributions may not be made to an employee's Roth 401(k) account.

For Whom Does a Roth 401(k) Make Sense?

Younger workers who will not be retiring for a long time might choose the advantages of tax-free income in the future over the benefits of deferring present income taxes. Lower-income workers also might find the benefits of future tax-free income to be worth more to them than the present tax deferral. They might anticipate that when they withdraw the money, they will be in a higher tax bracket. Workers who are not eligible for a regular Roth IRA because their adjusted gross income is too high might find that the Roth 401(k) gives them a tax-free retirement option. Finally, baby boomers who are looking at ever-increasing federal deficits might wish to opt for the Roth 401(k) as a hedge against what they might think are future income tax rate increases. And those who still cannot make up their minds can choose to do both: set up a regular 401(k) and a Roth 401(k), and split their contributions. Just remember that the total contributions to 401(k) accounts may not exceed the statutory limits.

Sunrise, Sunset

"Sunrise, Sunset" was the name of a hauntingly beautiful song from the musical Fiddler on the Roof, which ran for 3,242 performances on Broadway beginning on September 22, 1964.

Sunset might be beautiful when depicted in a song, but when it refers to the practice of Congress writing laws that quietly wipe out tax advantages previously granted, it is the name of a practice that would make Enron accountants blush. The federal government needs a certain amount of money to operate. When a tax break is granted to the public, Congress often puts a time limit on the availability of that particular tax break. By doing so, Congress can anticipate that future revenues needed to run the government will be restored at the end of a certain period. "Sunsetting" is the term for terminating such a law with a limited shelf life. Of course, this tactic is highly misleading: If there is a large enough public protest over the end of a particular tax break, Congress will make it permanent. That, in turn, could mean that Congress will not have enough money to operate future necessary programs without performing other accounting manipulations that are not drastically dissimilar to the misrepresentative accounting that sent several Enron officials to prison.

A good example of a law with sunset provisions is the federal estate tax. This law provides for the regular increasing of the amounts of assets that are exempt from federal estate taxes through the year 2009 when the exemption amount reaches a peak of 3.5 million dollars. Then in the year 2010, the estate tax will be totally abolished so that no one who dies in that year, regardless of the amount of assets contained in his or her estate, will be responsible for paying a federal estate tax. But then comes December 31, 2010, a day called by some people Throw Mama From the Train Day, referring to the 1987 movie directed by Danny DeVito and starring Billy Crystal. Under current law, that is the last day that estates will go untaxed because, on that day, the federal estate tax abolition sunsets. On January 1, 2011, not only does the federal estate tax return, but it does so at the reduced million-dollar exemption level of the year 2002. No one actually expects that scenario to occur, least of all the Congressmen who voted for such a sunset law. Most likely, they will play out the sunset game and either permanently abolish the estate tax (less likely) or pass a new law setting a permanent (or, at least, as permanent as any tax legislation can be) exemption amount.

I tell you all of this interesting information about sunset laws not just for your edification, but also because the Roth 401(k) law has a similar sunset provision. Like the federal estate tax, the Roth 401(k) is set to sunset on December 31, 2010, unless Congress takes further action. However, even if Congress were to permit the Roth 401(k) law to just fade away, such action would only prevent people from putting further money into a Roth 401(k). Funds already put into a Roth 401(k) could most likely be rolled over into a regular Roth IRA and would continue to provide benefits to those people who took advantage of this retirement tax break during the 5 years it was available.

Temptation

Temptation: good when you are talking about the Temptations, one of the greatest of the Motown groups. Temptation: bad when it causes you to take your money out of your 401(k) when you go to a new job, thereby turning an advantage of the 401(k) into a disadvantage. The law permits people to take a 401(k) account with them from one employer to another throughout their working careers. The law also allows three other choices.

The first option, which is less of a choice than just failure to make a decision (which, thereafter, becomes a decision), is merely leaving your 401(k) account with your former employer's plan. This is not necessarily a bad decision, but it does expose you to unnecessary additional management fees if you have 401(k) accounts with multiple employers.

A second option is to roll over your 401(k) from your previous employer into the plan of your next employer. This alternative can be used if you already have another job lined up when you leave your previous job. A key determining factor in deciding to choose this option is the choice of investments in your new employer's 401(k) plan. If the choices do not seem particularly attractive, you might want to take advantage of your third option: rolling over your 401(k) account from your previous employer into your own self-directed IRA.

Rolling over an employer-sponsored 401(k) into an IRA, traditional or Roth, makes a lot of sense for most people. People who leave a job for whatever reason have a right to either leave their retirement money in the company-sponsored 401(k) or have it rolled into an IRA that they themselves control. This enables former employees to invest their retirement money in whatever investments are allowed under IRA rules. The investment choices available to a former employee in a self-directed IRA are far broader than those available when a former employee leaves the money in the company's 401(k) plan. And whether you keep it in the company 401(k) plan or roll over the money into your own IRA, income tax deferral (or complete avoidance, in the case of a company-sponsored Roth 401[k] plan) is fully available to the former employee. There is one major consideration in deciding whether to leave the money in the company 401(k) or take it out and put it into an IRA, however: only workers who take out the money and roll it into their own IRAs can stretch an IRA through multiple generations, as described previously.

Then there is that temptation to just take the money and spend it. This is a lose, lose, lose proposition. You lose the benefit of having the money grow tax deferred in a 401(k) plan. You lose by paying income tax on the money you take out. And you lose by paying a 10 percent penalty for early withdrawal of your 401(k) account unless you are at least 59½ or come within one of the narrow statutory exceptions. Unfortunately, according to a Hewitt Associates study done in 2005, 45 percent of workers cash in their 401(k) accounts when they leave the company.

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