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The New Roth IRA

Beginning in 2006, employers can offer a brand-new option to 401(k) plan participants--the ability to make Roth 401(k) contributions. If you're lucky enough to work for an employer who offers this option, Roth contributions could play an important role in maximizing your retirement income.  

A Roth 401(k) is simply a traditional 401(k) plan that accepts Roth 401(k) contributions. Roth 401(k) contributions are made on an after-tax basis, just like Roth IRA contributions. This means there's no up-front tax benefit, but if certain conditions are met, your Roth 401(k) contributions and all accumulated investment earnings on those contributions are free from federal income tax when distributed from the plan. (Beginning in 2006, 403(b) plans can also allow Roth contributions.) 

Unlike Roth IRAs, where individuals who earn more than a certain dollar amount aren't allowed to contribute, you can make Roth contributions, regardless of your salary level, as soon as you are eligible to participate in the plan. And while a 401(k) plan can require employees to wait up to one year before they become eligible to contribute, many plans allow you to contribute beginning with your first paycheck. 

There's an overall cap on your combined pretax and Roth 401(k) contributions. If you're age 50 or older, you are eligible to extra contributions. You can split your contribution any way you wish. 

Keep in mind that if you also contribute to another employer's 401(k), 403(b), SIMPLE, or SAR-SEP plan, your total contributions to all of these plans--both pretax and Roth--can't exceed the IRS limits and these are adjusted yearly. Make sure you don't exceed these limits if you contribute to plans of more than one employer. Your participation in a Roth 401(k) plan has no impact on your ability to contribute to a Roth IRA. You can contribute to both if you wish (assuming you meet the Roth IRA income limits). 

When you make pretax 401(k) contributions, you don't pay current income taxes on those dollars (which means more take-home pay). But your contributions and investment earnings are fully taxable when you receive a distribution from the plan. In contrast, Roth 401(k) contributions are subject to income taxes up front, but qualified distributions of your contributions and earnings are entirely free from federal income tax. 

Which is the better option depends upon your personal situation. If you think you'll be in a similar or higher tax bracket when you retire, Roth 401(k) contributions may be more appealing, since you'll effectively lock in today's lower tax rates. However, if you think you'll be in a lower tax bracket when you retire, pretax 401(k) contributions may be more appropriate. Your investment horizon and projected investment results are also important factors. A financial professional can help you determine which course is best for you.

Because your Roth 401(k) contributions are made on an after-tax basis, they're always free from federal income tax when distributed from the plan. But the investment earnings on your Roth contributions are tax free only if you meet the requirements for a "qualified distribution". In general, a distribution is qualified only if it satisfies both of the following:

                 ·        It's made after the end of a five-year waiting period

                 ·        The payment is made after you turn 59½, become disabled, or die

Like pretax 401(k) contributions, your Roth 401(k) contributions and investment earnings can be paid from the plan only after you terminate employment, attain age 59½, become disabled, or die. Your Roth contributions (but not investment earnings) can also be distributed if you incur a hardship.

Also, unlike Roth IRAs, you must begin taking distributions from a Roth 401(k) plan after you reach age 70½ (or in some cases, after you retire). But this isn't as significant as it might seem, since you can generally roll over your Roth 401(k) dollars into a Roth IRA if you don't need or want the lifetime distributions.

Employers aren't required to make Roth contributions available in their 401(k) plans. So be sure to ask your employer if they are considering adding this exciting new feature to your 401(k) plan. 
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