The 401(k) plan works by the participants having the ability to route part of their salary to a retirement account on a pre-tax basis. The tax deferred growth continues until retirement, at which time, the money is withdrawn over a period of years and the distributions are taxed at the ordinary tax rate in effect for the year of withdraw.
Most of you are aware how the standard deductible 401(k) plan works. The participants have the ability to route part of their salary to a retirement account on a pre-tax basis. The tax deferred growth continues until retirement, at which time, the money is withdrawn over a period of years and the distributions are taxed at the ordinary tax rate in effect for the year of withdraw.
The major advantages of saving money thru a deductible 401(k) plan is that you should pay less tax in the year you contribute the money and the account should grow into an even larger sum of monies until retirement. At that point, when distributions come out, and the expected result is that retirees will be in a lower tax bracket then they were when they worked.
As many people retire, they are finding themselves in just as high of a tax bracket as when they worked, and the expected benefit of the tax deferred retirement accounts never really materializes. They are happy they have the money, but are unhappy with all the taxes due as a result of the distributions.
A popular (fairly new) option included in many 401k plans over the last couple years is the Roth 401(k). You should give serious consideration to utilizing this option, if it is available to you. The two major differences when comparing the Roth 401(k) to the deductible 401(k) plan are that 1) contributions are not made on a pre-tax basis and 2) the withdrawals are not taxable under current law.
The overall limit on all 401(k) contributions is $17,000 per year ($22,500 if you are age 50 or older and your plan allows for catch-up contributions). This annual limit can be contributed all to a deductible 401(k), all to a Roth 401(k), or split between the two, as long as the combined amounts do not exceed the annual contribution limit. If your employer provides a matching contribution, the match must all be contributed to the deductible portion of the 401k account, even if all employee contributions are going into the Roth 401(k).
Roth accounts are not subject to Required Minimum Distribution (RMD) requirements until after the owner passes away, which make them very friendly when it comes to estate planning. There is some sentiment that Congress will figure out a way to include Roth distributions in the definition of taxable income, but until that actually happens; I do not think you should rule out contributing to your Roth account. In my opinion, Roth accounts should be utilized, to the extent possible, in order to give you a combination of taxable and non-taxable income in retirement.
Rich Weidrick is a CPA and a principal of Weidrick, Livesay, Mitchell & Burge, LLC, in Akron.
MD News March/April 2012, Cleveland/Akron/Canton