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 Pretax
contributions have long been one of the benefits of saving for
retirement in a 401(k) plan. With pretax contributions,
the salary you contribute to the plan is not immediately taxable.
This benefit allows you to set aside more money than you would if
you paid income taxes first, then put the amount remaining after
taxes into your savings. Pretax contributions and related investment
earnings are taxable when distributed
from the plan, unless you roll the money into another eligible plan
or an individual
retirement account (IRA).
Roth Option Works Differently Starting as early as this year, 401(k) plans may offer a “Roth” contribution option. Roth contributions are made on an after-tax basis, so you give up the immediate tax benefit you get when you make pretax contributions. But you gain another benefit in return: Withdrawals of Roth 401(k) money, including investment earnings, are potentially tax free. Tax-free treatment is available once five years have elapsed from the time of your first Roth contribution and you’ve reached age 59½. After five years, distributions made on account of your disability or death are also tax free. Weigh Several Factors Should you take advantage of the Roth 401(k) option if your employer’s plan offers it? Maybe. But you’ll want to make your decision carefully. Here are some factors that could be important: Your current tax bracket. The higher it is, the more you’ll give up in terms of an immediate tax benefit if you choose the Roth option.Your future tax bracket. The lower it is at the time you withdraw your pretax savings, the less tax you’ll owe on the withdrawal. Liquidating your account slowly after you retire may spread out the tax liability and help you stay in a lower bracket. The unknown is whether rates will increase in the future.Time to retirement. The younger you are, the more you may benefit from the Roth option because tax-free investment earnings can compound for a longer period. Contribution amount. You may decide against the Roth option if you think you’ll have to cut back on the amount you are saving in order to keep your paycheck the same after taxes on your contribution are taken out. Building an adequate nest egg may be more important than saving taxes. Estate planning. If you don’t think you’ll need to use all your retirement savings, making Roth contributions at work and later rolling the funds over into a Roth IRA could allow you to provide your beneficiaries with a source of income-tax-free funds. |
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