Most people are familiar with defined contribution retirement plans, also referred to as 403(b) and 457(b) plans. You don’t pay income taxes on contributions in the year you earn the money, so it’s a nice incentive to save, especially if you’re in a high tax bracket. Since 2006, there has been another option. If your employer offers a 401(k) plan, it can add a Roth option. But what’s the difference?
Contributions to a traditional 401(k) grow (we hope), tax deferred. But deferred just means you pay later. Distributions (meaning the money goes to you, not to another retirement plan) are considered income in the year you take them and are taxed at that year’s rate. So you could pay a higher tax rate when you take out money than you would have paid on it when you put it in.
Like Roth IRA contributions, Roth 401(k) contributions are not tax deductible, but withdrawals of contributions and earnings are not taxed, provided it’s a qualified distribution. Roths are aimed at young people in low tax brackets who expect to be in a higher bracket in retirement. However, they can also be attractive to someone looking for tax-free retirement income or an estate-planning tool.
Unlike other retirement accounts, you never have to take distributions from your own Roth IRA. You can pass it on, untouched, to your beneficiaries. But you can only put $5,500 ($6,500 for those age 50 or older) into a Roth IRA in 2013, and it’s possible to have an income that disqualifies you from even making a contribution.
A Roth 401(k) doesn’t have income limits, and this year, you can contribute $17,500 ($23,000 for those age 50 or older). However, with a Roth 401(k), distributions must begin when you turn age 70½, unless you are still working and not a 5 percent owner of the company sponsoring the plan. When you leave your job, you can roll your Roth 401(k) into a Roth IRA, and it can stay there until you die and pass it on to someone else, who can let it grow and stretch payments out over their lifetime.
You can make Traditional or Roth contributions, or both, as long as the total amount stays within the annual limits. If the plan document permits, your employer can match your Roth contributions, as well, but it will be added to the tax-deferred account.
Is the Roth option right for you? Carefully consider your own situation and current laws. In addition, consult with your tax and financial advisors. If your plan doesn’t offer a Roth option, make sure that your employer knows it’s available.