This tax benefit can only be provided to persons who are at least 59.5 years old, or are disabled, and who have held the account for a minimum period of five years. Roth 401k provides an opportunity to save with a different kind of tax treatment. It is a good option for those who are just starting their careers, and expect their income to grow in the future.
Eligibility:
Anyone whose employer offers Roth 401k is eligible for this investment option. If an employee leaves his/her job, the balance can be rolled over. One major benefit of enrolling is that an account holder does not lose eligibility when the income becomes very high. There is no provision of helping a person open this account if his/her employer does not offer Roth 401k yet. Employers provide a form to their employees to state some, or all, of their 401k contributions that will go into their account.
Difference between 401k and Roth 401k:
401k makes available some tax relief in the year a person may have contributed into the account. However, a 401k-account holder is liable to pay taxes on his/her contribution, along with all the investment earnings, later.
A Roth 401k account holder does not get any tax benefit in the year of the contributions, but all the earnings in the account will be free of tax for as long as the account exists. Besides, a holder can roll his/her account to a Roth IRA. The Roth IRA account continues to grow with tax-free earnings for as long as it exists. However, Roth IRA is not available to taxpayers with an income above a certain level.
Advantages of Roth 401k:
Since tax rules allow a person to make it as large as a traditional account, the Roth 401k account is more valuable compared to it. Therefore, saving in a Roth 401k account can make a person much better off at retirement. Given below is a table showing the amount required in a traditional account to have the equivalent of $100 in a Roth Account.
If a person is in the 33% tax bracket, he/she will have to withdraw $149.25 from a traditional account in order to spend $100. This is because $49.25 is used to pay the tax on the distribution. This provides more wealth at retirement, as the distribution from it is tax-free.
While many companies that already have the traditional 401k plans, wanted to implement Roth 401k plans, which have been effective from January 1,2006 according to the law, in reality only a few actually have done it, because of the extra expenses involved. These companies want to first observe the success of Roth 401k before actually undertaking the cost of the implementation.
Roth 401k is a good investment option to save tax-free earnings for retirement. People can take advantage of it to be able to have a secure retirement, which is free from monetary worries.
January 1, 2006, a new opportunity for retirement savings came to town. Known as the post tax ROTH 401k - this is the classier sister to the traditional 401k plan. In one corner is the post tax Roth 401k, with a fuller bodied contribution as taxes are included on the front end. There's also a five year wait to end the relationship and take a tax free withdrawal. In the other corner is the pre-tax traditional 401k, a tax stripped model with no wait on distributions. But you pay the taxman for both the 401k contribution and the 401k earnings on premature withdrawal and retirement.
Now comes the trouble--- which 401k sister to choose?
Ready to roll the dice? You're going to have to consider the following: The tax code structure-will the tax structure be more difficult when you are ready to retire? The marginal tax rates-will they be higher or lower at your retirement? The inflation rates-will they be too low or too high for you to benefit?
So which sister will it be? --The pre-tax traditional 401k or the post tax Roth 401k--
If you are among the highly compensated, (those earning $95,000+ in 2005), or a business owner, you may find yourself better off with the post tax Roth 401k. Although contributions are counted dollar for dollar, Roth 401k contributions are worth more to the highly compensated than the pre-tax dollars. As an example, in a company, that fails the non-discrimination ADP test or limits the deferrals of the highly compensated to avoid failing the ADP, and assuming an individual's tax rate remains the same, making a Roth deferral is economically equivalent to increasing a pre-tax deferral by the amount of the tax savings.
Example: Company B maintains a 401(k) plan. James, age 49, earns $220,000/year and would like to defer the maximum each year. Unfortunately, the average deferral rate of the Non Highly Compensated Employees (NHCE) is 3%, thus limiting James? deferral rate to 5% ($11,000). The same limitation would apply if the plan added a Roth feature. However, assuming a 35% combined (total fed & state) marginal tax rate, the $11,000 Roth post tax contribution would be the same as making a traditional 401k $14,850 pre-tax contribution.
With the Roth 401k, James will not only make a larger deferral but one that is the same as the pretax deferral in excess of the dollar limit, and more than the ADP test limit. While it is true that James can only defer $11,000 either way, his deferral dollars go farther with a Roth. And if James was a business owner in a Solo 401k Plan, there would be no non-discrimination ADP limit at all.
Both Joseph Kenny & Lawrence Groves are contributors for EditorialToday. The above articles have been edited for relevancy and timeliness. All write-ups, reviews, tips and guides published by EditorialToday.com and its partners or affiliates are for informational purposes only. They should not be used for any legal or any other type of advice. We do not endorse any author, contributor, writer or article posted by our team.
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