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Roth 401(k) - Saving For Retirement Tax-Free

Combine the best features of a 401(k) and a Roth IRA with a Roth 401(k)

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The Roth 401(k) was created several years ago. But since the Roth 401(k) was originally set to expire before the end of the decade, few companies bothered to establish Roth 401(k)s for their employees. Back in 2006, Congress fortunately made the Roth 401(k) permanent.

If you have a Roth 401(k) option at work, it’s important to understand how and when to take advantage. If you don’t have a Roth 401(k) option at work, it still makes sense to understand what you just might want to let your benefits department know they’re missing out on.

How a Roth 401(k) Works

Like contributions to a Roth IRA, contributions to a Roth 401(k) are not tax-deductible. Effectively, you use after-tax dollars to fund your contribution. However, when the money is one day distributed to you during retirement, the entire account is tax-free. (A regular IRA and 401(k), on the other hand, are tax-deferred, meaning you’ll pay plenty of taxes on your distributions during retirement).

No Income Restrictions

Making a contribution to a Roth IRA is only allowed if your income is below certain limits. No such limits for a Roth 401(k) plan exist, however.

Higher Contribution Limits

Roth IRA contributions are limited to $5,000 (2009) or $6,000 (2009, if 50 or older). But Roth 401(k) contributions can be as high as $16,500 (2009) or $22,000 (2009, if 50 or older). Note, however, that these limits are the total permitted for all 401(k) contributions. As such, should you, as a 45 year-old, choose to contribute $10,000 to a regular 401(k) in 2009, the most you could contribute to a Roth IRA is $6,500. You could also make an IRA contribution, however.

Employer Matching Contributions

Whether or not you receive a matching contribution from your company is determined by your employer. If you receive one, it is made pre-tax and is held separately from your Roth 401(k).

Roth 401(k) vs. Regular 401(k)

Choosing which plan to participate in, if your employer gives you both options, might be difficult. While there are many variables to consider, the most important is your anticipated income tax rate in retirement compared to your current income tax rate. The more likely you feel that your future income tax rate will be higher, the more attractive a Roth is. As such, young people who may be in relatively low tax brackets today should most seriously consider a Roth 401(k).

Roth 401(k) is a Company Decision

Not every company has a 401(k) plan and not every company with a 401(k) plan has chosen to add a Roth 401(k) plan. If you don’t see the option listed in your benefits book, ask your benefits representative. If your employer receives enough requests, the company just might add it.

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