Roth IRA accounts are a relatively new way to save for retirement. Changes in the tax laws made these accounts available beginning in 2001 for certain taxpayers.
Conventional IRA accounts permit you to put away money on a pre-tax basis. At retirement, amounts withdrawn from the IRA account are taxed as ordinary income at your current tax rate in the year you make the withdrawal. But, with a Roth IRA, you can contribute money on an after-tax basis, and taxes are paid at your current tax rate when you make the contribution.
At retirement, amounts withdrawn from a Roth IRA completely escape taxes. This tax treatment is exactly the opposite from the tax treatment for a conventional IRA. While taxes are paid when the money is contributed, you can make withdraws without double taxation.
The major attraction with Roth IRA accounts is that earnings can be withdrawn without ever being subject to taxes. With a conventional IRA, all earnings are taxed when withdrawn.
Currently, you are eligible to contribute to a Roth IRA only if your income is below $110,000 if you file as a single person or below $160,000 if you file jointly.
Beginning in 2006, the Roth 401(k) account adds a new dimension.
Roth accounts will be available to anyone who participates in a 401(k) plan offering the new Roth 401(k) account as an option. The income thresholds have been eliminated; everyone is eligible to contribute regardless of income.
For 2006, the maximum amount that can be contributed is $15,000, unless you are over age 50, then you can contribute an additional $5,000 if you belong to a plan that allows "catch-ups."
Now or later
Does the new Roth 401(k) account make sense for you? The answer depends on what you think will happen to your financial picture in the future.
Here are some reasons why the Roth 401(k) might be the best choice for your retirement contributions.
If you are a young worker and have a relatively low tax bracket, you may want to pay taxes today at a lower rate and take advantage of tax-free withdrawals in retirement. The earnings may grow to substantial amounts over the years, and your withdrawals will be tax-free.
If you believe you will be in a higher tax bracket when you retire. You may want to pay taxes at your current lower rate and contribute the maximum to a Roth 401(k).
Taxpayers who think all federal income tax rates will be higher in future years, especially for high net-worth people, should consider paying taxes now.
Another consideration for many is that the current tax laws are not a guarantee. The Roth IRA and Roth 401(k) provisions will expire in 2010 unless Congress votes to extend the current laws.
A final consideration is your timeline for retirement. If you plan to retire 10 years or more into the future, your tax-deferred earnings may grow to a substantial amount. If your retirement horizon is closer, you should consider your tax bracket in retirement as a deciding factor.
A very practical solution might be to "hedge your bets." You will be permitted to contribute to both the conventional 401(k) and the Roth 401(k) in any combination. As long as your total salary deferrals do not exceed the maximum, you may pick and choose the type of account that works best for you.
In other words, you have three choices: 1, direct all your contributions to the conventional IRA; 2, direct all your contributions to a Roth 401(k); or 3, split your contributions between the two accounts.
Now that you have considered all the options, deciding what is best for you will ultimately depend on whether your employer decides to offer the Roth 401(k) option.
Some employers think it will increase the complexity and cost of administering their plans. Others may think the option will not be understood or appreciated by their employees. The jury is still out. Although 14.3 million households already own a Roth IRA, employers don't know how many employees would sign up for the Roth 401(k).
Employers know they will have to modify payroll systems and make changes to their retirement plans if they offer the Roth 401(k).
Hewitt Associates, an employee benefits consulting firm, surveyed 440 employers and found that only a third were "likely" or "very likely" to offer the Roth 401(k) when it becomes available in 2006.
Employers are willing to make these changes only if their employees value this addition to their retirement offerings. However, educating employees about the pros and cons of the Roth 401(k) option will be the necessary if the employer adds this element to their retirement plan.
The Roth 401(k) option will most likely get off to a slow start. If it seems right for you, make your voice heard.
Talk to your employer and ask if the company is willing to make the option available in your plan. As the option becomes more popular, employers will become more comfortable adding this option to their existing plans.
Fletcher is senior manager in the Audit and Assurance Services Group at Indianapolis-based accounting firm Katz, Sapper & Miller. Views expressed here are the writer's.