A Closer Look At The Roth 401k
Roth 401k is a good retirement savings option. Although it does not provide an up-front tax-deduction, the account eventually becomes tax-free, because the withdrawals taken at retirement are not subject to income tax.
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 for Roth 401k:
Anyone whose employer offers Roth 401k is eligible for this investment option. If an employee leaves his/her job, the Roth 401k balance can be rolled over into a Roth IRA. One major benefit of enrolling in Roth 401k 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 Roth 401k 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 Roth 401k-account 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.
TAX- BRACKET AMOUNT
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. Roth 401k 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.
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Understanding The Roth Ira
The ROTH IRA is a retirement product which allows the withdrawal of tax free income from a tax deferred account, and it is a fantastic savings vehicle for people of any age, but particularly for younger people. Congress created The Roth IRA on January 1, 1998 as a result of the Taxpayer Relief Act of 1997. It's named after the late Senator William V. Roth, Jr. The Roth IRA is different from the Traditional IRA because it provides no deduction for contributions, but if you meet certain requirements, all earnings are tax free when you or your beneficiary withdraw them, whereas with the Traditional IRA taxes would be due upon withdrawal. Some other benefits of the ROTH IRA are no early distribution penalty on certain withdrawals, and there is no requirement to take minimum distributions after age 70½.
While the decision to use a ROTH IRA is based on several factors, the presence of a retirement plan in the workplace is one of the major reasons for utilizing a ROTH IRA. If you still have the ability to save, after committing the maximum contribution to your 401k plan, then the ROTH IRA makes sense, because you are limited in the tax deductibility of contributions to a Traditional IRA, if you have a workplace pension plan or 401k. For people who have no workplace retirement plan, the bottom line is that most people are better off with the Roth IRA. The reason is that the dollar amount in Roth IRA is effectively larger than a Traditional IRA because it holds after-tax dollars. If you can take advantage of this feature of the Roth IRA by maximizing your contributions you'll add greater tax leverage to your retirement savings.
There are two ways to establish a Roth IRA either by making a regular contribution to a Roth IRA or by converting a traditional IRA to a Roth IRA. As mentioned before, contributions can be made to a Roth IRA even if you participate in a workplace retirement plan. These contributions can be as much as $4,000 for 2007 with a $1,000 catchup for those 50 and older. There are just two requirements for contributing to the ROTH IRA. First, you or your spouse must have compensation or alimony income equal to the amount contributed. Secondly, your modified adjusted gross income can't exceed certain limits. For the maximum contribution, the limits are $99,000 for single individuals and $156,000 for married couples filing joint returns. The amount you can contribute is reduced gradually and then completely eliminated when your modified adjusted gross income exceeds $114,000 for single individuals or $166,000 for married couples filing jointly. These dollar amounts apply through 2007. You can convert your regular IRA to a Roth IRA if your modified adjusted gross income is $100,000 or less, and if you're single or file jointly with your spouse. You'll have to pay tax in the year of the conversion, but for many people the long-term savings is preferrable to consequesnces of the tax incurred.
Distributions from Roth IRAs are tax-free until you've withdrawn all your regular contributions. After that you'll withdraw your conversion contributions, if any. Special rules apply when you withdraw your conversion contributions. When you've withdrawn all your regular and conversion contributions, any subsequent withdrawals come from earnings. The withdrawals are tax-free if you're over age 59½ and at least five years have expired since you established your Roth IRA. Otherwise, with a few exceptions, they're taxable and potentially subject to the early withdrawal penalty.
Could a Roth IRA be Better Than a 401(k)?
Very few people whom I know are familiar with the benefits of the Roth IRA. It was named for the late Senator William Roth of Rhode Island, who proposed it. It is similar to a traditional IRA except contributions are never tax-deductible. Contributions to traditional IRAs are sometimes deductible or partially deductible, depending on your income and whether or not you have a retirement plan like a 401(k) at work. With Roth IRAs, individuals are limited to incomes of $95,000 ($150,000 for couples) to be eligible for full contribution amounts.
However, unlike the traditional IRA, you can withdraw your contributions from a Roth IRA at any time, at any age without penalty. Earnings are not taxed if you wait until at least age 59 1/2 to begin withdrawing them and have held your Roth IRA for at least five years. With a Roth IRA, the contributions are taxed without any deferment, but they grow tax-free and the gains are never taxed (see above). With a 401(k), contributions are tax-deferred, but eventually the contributions and gains will be taxed. By the time most people retire, the earnings from their retirement accounts will far exceed their contributions, due to compounding. With that in mind, one could make the case for a Roth IRA possibly being better than a 401(k).
Here's an illustration. Let's suppose that over the course of 25 years you contributed a total of $75,000 to your 401(k) and your employer kicked in $30,000 during that same period for a total of $105,000. By the end of those 25 years, your compounded gains (assuming you're getting a decent rate of return) could total $500,000. When you retire, you will eventually pay taxes on the entire $605,000 as well as the gains you receive from it after retirement. Now, let's assume that, instead of contributing to your 401(k) for those 25 years, you contributed only $50,000 to your Roth IRA (without a matching contribution from your employer, of course). The assumption is also that you would not be able to contribute as much because you are using post-tax dollars for the Roth IRA vs. pre-tax dollars for the 401(k). However, because you generally have more investment options with the Roth IRA money than with the 401(k) money, you are likely to find a better rate of return. With that in mind, let's say your compounded gains could total $400,000. When you retire, you could have the entire $450,000 as well as the gains you could receive from it post-retirement, completely tax free!
As you can see, it is possible that many people could come out better putting at least a portion of their retirement funds into a Roth IRA. Judge for yourself. I actually contribute more to my Roth IRA than I do to my 401(k). I put just enough into my 401(k) to get my employer's maximum matching contribution, and that's all. However, I'm not a financial advisor and I don't play one on TV, so check with your financial advisor to see what would be right for you. For more information about the Roth IRA, see the following link: http://www.rothira.com.
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Rolling your 401k: Contributory IRA vs. Rollover IRA
In an ideal world you would start your working career with a great company in your early 20s, steadily climb the corporate ladder, retire at age 65, and draw a sufficient income from your accumulated 401k account to live happily ever after.
Unfortunately, that’s not how the real world works. If you are like most people, you will change careers, or at least companies, several times. Each time, you'll be faced with the question of what to do with your accumulated 401k benefits.
You will likely have a few choices: keep your 401k with your old employer (sometimes possible), roll the proceeds into your new employer's 401k plan, or put them directly into a self-directed IRA at a brokerage firm of your choice.
Since leaving your 401k with your ex-employer has no benefits whatsoever and most employers will prefer you transfer out anyway, that leaves only the last two as viable options:
1. Roll your 401k proceeds into the new employer's 401k plan of (if allowed)
This is the most painless solution and the one that does not require much decision making. While this is certainly acceptable, there is a bigger picture.
The ultimate goal of having a 401k plan is to provide you with a comfortable retirement. To accomplish this you really need a wide variety of investment choices and the opportunity to move among them in response to market variations.
Most 401ks are limited to maybe 15 mutual fund choices which rarely change, even if market behavior dictates they should. Additionally, the canned advice provided through plan sponsors is generally not terribly useful.
The only benefit to this type of rollover is that if your plan has a loan provision, you’ll be able to borrow funds easily.
2. Roll your 401k proceeds into a self directed IRA
This is the preferable solution for most people, and with it you again have two choices: roll your 401k into a “Contributory” or a “Rollover” IRA.
Once you roll your proceeds into this type of IRA, you may still contribute annually if you qualify (check with your accountant). However, the 401k portion can no longer be rolled back into another 401k with a new employer, should you ever want to do that. So you eliminate the possibility of using the loan provision with those funds. While it is possible to borrow against an IRA, it’s more limited than borrowing against an employer 401k. Check with your tax preparer for details.
This type of IRA allows you the most flexibility. You may roll the proceeds back into a 401k plan if you want to utilize a loan provision. However, for tax reasons you should not make annual contributions to this IRA. If making annual contributions becomes important to you, simply open another contributory IRA.
Since Rollover IRAs are usually set up at a brokerage firm, you’ll have access to their entire universe of mutual funds. With this type of IRA, you can also employ an independent investment advisor to manage the account for you. (Yes there is a cost for that, but an effective advisor will more than make up for that in greater returns than you would get without him or her.)
Most of my clients have found that the investment results we've obtained with their personal IRAs were far superior to those yielded by their employer 401k plans or their personal investing efforts. This has been mainly due to a combination of better choices and a methodical approach to investing which has kept my clients in the market during good times and out of it altogether during severe declines.
Bottom line: Rollover IRAs offer opportunities to maximize benefits and provide flexibility not usually available with employer 401k plans.