Your Money: Roth 401(k)

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Tax-Free Allure

By Jonathan Lederer, CFA

Most business owners have heard about the new Roth 401(k), but many have yet to incorporate this retirement plan option. They may be depriving their employees of a productive means of generating more after-tax income in retirement.
     That said, the Roth 401(k) may not fully benefit everyone, as those who foresee their tax rates falling and those with the discipline and financial capacity to invest tax savings from pretax contributions may be better off in a traditional 401(k) plan.

How It Works
The Roth 401(k) is very similar to the Roth IRA in that plan participants contribute aftertax money (i.e., con-tributions do not reduce taxable income) but can withdraw funds tax-free after age 59½ if they have held the account for at least five years. These characteristics are in stark contrast to traditional 401(k)s and IRAs, where investors contribute funds on a pretax basis but must pay taxes on distributions. Investments grow tax-free in both traditional and Roth accounts.
     Roth 401(k) participants may contribute up to $15,000 in 2006. Those older than 50 may contribute an extra $5,000 this year in “catch-up” provisions. These contribution limits gradually increase through 2010, at which time the provisions of the Roth 401(k) law, passed in 2001, expire. Though most observers expect Congress to extend the law, Roth participants will no longer be able to contribute to their funds should Congress not act. In this scenario, funds already invested could still grow and be withdrawn tax-free.
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