Roth 401k and Traditional 401k Plans – Comparisons, Benefits & 2010 Income and Contribution Limits

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[2013 Update] With a deal to avert the fiscal cliff reached and legislated under the American Taxpayer Relief Act (ATRA) of 2012, a couple of significant employer sponsored retirement plan features have reappeared with some modifications. This includes the Roth 401(k) conversion and Charitable IRA contributions. You can read more about these updated provisions in this article.

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Over the last few years many company sponsored 401(k) plans have begun offering participants the ability to put money into either a Traditional 401(k) or a Roth 401(k) account. While much attention has been focused on the opportunities for traditional 401(k) plans with an externally held Roth IRA plan, there has been little emphasis on using the Roth 401(k) option. In fact, for many workers the Roth 401(k) could be a better retirement investment option than a traditional 401(k) or Roth IRA. Even better, you can combine a Roth 401k and Traditional 401k to harness the benefits of either option. The table below provides a summary and comparison of the 401(k) plan options and those of a traditional IRA. But first, here are the key points to keep in mind around the 401(k) plans on offer and determining which is best for you:

- In 2010 and 2011 the 401(k) plans allow you to contribute up to $16,500 if you’re under age 50, and $22,000 if age 50 or over. This limit applies to the entire 401(k) plan, no matter if it’s a Roth or a Traditional 401(k) plan, or a combination of both. So you can’t save $16,500 in a regular 401(k) and another $16,500 in a Roth 401(k).
- The Traditional Roth 401(k) contribution limit is much higher than the $5,000 (under age 50) and $6,000 (age 50 or older) limits for Roth IRAs. Thus, you can shovel a lot more money into a Roth 401(k) than you can a Roth IRA.
- The Roth 401(k) can offer advantages to high-income individuals who haven’t been able to contribute to a Roth IRA because of the income restrictions. (In 2010, eligibility for a Roth IRA phases out between $105,000 and $120,000 for single filers and $167,000 to $177,000 for those who are married and file jointly). There are no income restrictions for Roth 401(k)s.
- With the traditional 401(k) account, you receive an income tax deduction for the amount contributed to the plan; the money grows tax deferred until retirement, and then you pay income tax on the funds as they are withdrawn each year. With a Roth 401(k), you don’t get a current income tax deduction for your contribution, but the money grows tax free like in a Roth IRA. That means you don’t pay any tax on the gains between the time you contribute the money and your retirement, and you don’t pay any income taxes once you take the money out in retirement.
- Which to Use? A traditional or Roth 401(k) account? It comes down to what you think your tax rate during your working life and in retirement will be. So,
* If you think you’ll be in a higher bracket once retired, you would use the Roth feature. You forgo the income tax deduction today, but avoid higher taxes later
* If you think you’ll be in a lower tax bracket in retirement, you would use the traditional 401(k). You get a big tax deduction today, and when you pull the money out, you pay a lower tax on the increased value
* If your tax rate before and after retirement is the same, it doesn’t matter which one you use; you’ll end up with the same amount of after tax money
- If you are really unsure about your future and post-retirement tax rates you should consider splitting your 401(k) contributions between the traditional plan and the Roth plans. That way you get a deduction on some of your money today, and may well pay a lower tax on some of that when it comes out in retirement. At the same time you’re also adding to the Roth, which gives you a hedge against the possibility that you’ll be in a higher bracket for some of your money in retirement. Then once you retire, you have two sources of funds to utilize to manage your tax exposure each year.
- Anyone whose employer offers it is eligible for a Roth 401(k). However due to administrative costs associated with managing the plan, not all employers offer the Roth 401(k) option. If this is the case you should consult with your HR/benefits group about adding this option.
- Employer matches will still be made with pre-tax dollars like a traditional 401(k) plan, so if you only have the Roth 401(k) option the matching funds will accumulate in a separate account that is taxed as ordinary income at withdrawal.
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{ 6 comments… read them below or add one }

michael Burger March 13, 2012 at 12:45 pm

I made a over payment to my roth ira of 6,000 because my agi was over 179,000 for the year 2011 .the bank will only return it as a normal distrubition.how do i get it back as a refund.

Thanks For your help
Mike b.

Reply

andys2i March 14, 2012 at 10:14 am

You need to contact your Roth IRA provider about getting the money refunded to you. That is really the only way for them to issue you the funds. You need to emphasize that you want a refund and not a distribution. If your investment did earn interest income, those would be taxable income. They will issue you a 1099.

If you are correcting an excess contribution before your tax-filing deadline, the Internal Revenue Service (IRS) requires a calculation to determine the earnings or loss on the excess IRA contribution. The earnings or loss amount is factored into the amount of your return of excess distribution. Your Roth IRA provider should automatically calculate the amount of earnings or loss based on IRS Notice 2000-39 and IRS Final Regulation 1.408-11.

My suggestion for the future is that you wait until the end of the year to fund your Roth IRA to avoid this problem.

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Ren April 16, 2010 at 4:46 pm

>One factor that seems missing in your comparison of Roth 401(k) with traditional is that the Roth version has an *effective* higher contribution limit, since the taxes are not included in the limit. Thus, when you state that if you expect your taxes now and after retirement to be the same, then they are equal, that isn't quite correct if you are able to contribute up to the maximum.

Also, there is an additional factor to consider for higher income earners. It's not just your marginal rate that comes into play as the higher AGI you get with the Roth contribution can have other tax consequences such as triggering deduction and exemption phase-outs or even AMT. On the other hand, if you are already faced with AMT, shifting some contributions to Roth may be beneficial as they would only be taxed at the lower AMT rate.

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Navin April 16, 2010 at 7:16 am

>Contributing to a 401(k) plan lowers your income depending on the income taxes. But you must still pay Social Security and Medicare taxes on your pre-contribution income. These taxes are taken off the top, in spite of of retirement plan contributions. But the advantage is that taking part in a 401(k) plan will in no way decrease your potential Social Security benefits.

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mike April 14, 2010 at 10:55 pm

>Andy,
good comparison and discussion on the roth. I think it's still a tough call – but it's hard to image that taxes won't be higher, and a lot higher, in the future, so I have to think a roth makes more sense. Plus, I think, with a roth you aren't forced to pull money out, but with a regular 401k you are forced to pull money out – which is then counted as income and could reduce your social security payments. Is this right? Thanks, Mike

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Anonymous April 13, 2010 at 2:41 am

>Employees that work in a company without a Roth 401(k) should ask their employer to amend their plan to include it. This is typically a very nominal cost to business owners. If you're a business owner and don't have a 401(k) plan yet, you may want to consider adding one as the cost for those with less than 10-20 employees can be less than your personal and business tax benefits.

Converting to a Roth IRA can be a great idea, but for a lot of folks short on the cash to cover up-front taxes, an unrealistic one. Building into a Roth position is another option that may be a better fit.

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