A client recently contacted me because is employer was offering a new retirement plan called a Roth 401k plan. Below is my best recollection of the conversation:
Client: What the heck is a Roth 401k Plan?
Me: It combines what’s good about a Roth IRA and a 401(k) plan together.
Client: Can you help me out a little more here? I’m not totally sure what that means.
Me: OK, remember with a Roth IRA you don’t get a tax deduction but your money grows tax free, meaning that you don’t pay any tax on it even when you take it out.
Client: Yup, got it.
Me: Well a Roth 401k works the same way, you contributions grow tax-free and there’s no tax when you take the money out. In addition, you are not required withdraw the money as you are with a regular 401k, or Traditional IRA.
Client: But don’t I lose because I no longer get the tax deduction?
Me: You would only lose if tax rates are dramatically lower when you withdraw the money than they are now. I consider that possibility to be highly unlikely. With the projected costs of Social Security, Medicare, and Medicaid taxes are likely to be higher in the future than they are now unless we are willing to significantly cut benefit levels. Plus because you are not required to take withdrawals from a Roth 401k plan you have both taxable and tax-free income streams in retirement which gives you some ability to manage your tax bill.
Client: Ok, I get the part about the best of the Roth IRA, where does the best of the 401k come in?
Me: Well, with a Roth IRA you can only contribute up to $4,000/year ($5,000 if you are 50 or older), and you can’t contribute at all if you adjusted gross income (AGI) is over $160,000/year (for married filing jointly). With a Roth 401k you can contribute up to $15,500 in 2007 ($20,500 if you are 50 or older) and there is no income restriction.
Client: Sounds pretty good, I was planning to contribute to it anyway but I wanted to check it out with you first just to make sure there was something bad about it that I didn’t know about. By the way, when I leave my current employer can I roll my Roth 401k into a Roth IRA?
Me: You got it! Just as you can roll a regular 401k into a Traditional IRA, you can roll a Roth 401k into a Roth IRA.
Client: Cool.