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A FROTHy Deferral Decision: Roth 401(k) or Traditional 401(k)?

By:  Kristin Guenthardt, WMS - Associate Vice President, Investments

When 401(k) enrollment time rolls around, many eligible 401(k) participants must decide among the traditional pre-tax 401(k) salary deferral, the new after-tax Roth 401(k) salary deferral, and, perhaps, splitting their salary deferrals among the two, for example, 50% designated as pre-tax and 50% designated as after-tax. Let's take a quick look at some of the basic information required to be able to make a knowledgeable decision.

The Roth 401(k) builds on the Roth IRA concept. So, that seems to be the appropriate starting place for our discussion. The Roth IRA after-tax contribution limit for 2007 is $4,000, plus a catch-up contribution of $1,000 for those who have attained age 50 or higher. What makes the Roth IRA so attractive is that there are NO Required Minimum Distributions (RMDs) and Qualified Distributions of contributions and earnings thereon are tax-free. However, the Roth IRA is not available to everyone. For 2007, the ability to make an after-tax Roth IRA contribution is restricted to those whose AGI exceeds $99,000 for single filers and $156,000 for married filers. Fortunately, for high wage earners, this Roth IRA income restriction does not apply to 401(k) plans.

Eligible traditional 401(k) plan participants may make a 2007 salary deferral of up to $15,500, plus a catch-up contribution of $5,000 for those who have attained age 50 or higher. An advantage to the traditional 401(k) plan is that salary deferral is on a pre-tax basis, which means it is not included in taxable income for the year in which it is deferred. The downside to the traditional 401(k) is that once a participant attains age 70 ½, RMDs must be taken and distributions are subject to ordinary income tax.

A Roth 401(k) plan sidesteps the Roth IRA restriction on income and combines the attractions of the Roth IRA with the higher salary deferral limits of the traditional 401(k). Regardless of income, eligible Roth 401(k) participants may make a full Roth 401(k) salary deferral of up to $15,500, plus the $5,000 catch-up contribution. The Roth 401(k) is still a 401(k) plan, however, so RMDs must begin at age 70 ½. This, because it is anticipated, man be incorporated into financial plans and the salary deferral decision at hand.

A large number of factors come into play in deciding whether to make a traditional 401(k) contribution, a Roth 401(k) contribution or, if permissible, a combination of the two. Tax considerations will have a major impact on the decision. For example, the value of the current benefit to a pre-tax traditional 401(k) salary deferral must be weighed against the future recovery of tax-free earnings with the Roth 401(k) salary deferral. Proper examination of the tax savings factor alone requires financial analysis incorporating modeling tools which also take into consideration expected earnings rates, length of time before distributions will begin, and the anticipated size and frequency of distributions.   

Investors agree: saving for retirement is important. As more and different types of retirement savings accounts become available, selecting the most appropriate savings vehicle becomes more complex. If you would like to know more about the Roth 401(k), the traditional 401(k), the Roth IRA, or retirement savings in general, contact your financial advisor. After all, the harder your money works for you now, the more secure you are likely to be upon retirement.



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