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Pinnacle Resource Center

Roth 401(k) can help you avoid taxes in retirement
By Dale Beals, Senior Vice President, Pinnacle Asset Management and Registered Representative, Raymond James Financial Services, Inc.

More and more employers are beginning to offer Roth 401(k)s, a hybrid between a regular 401(k) plan and a Roth IRA, as an option to save for retirement.

Made permanent by Congress in 2006, the Roth 401(k) lets you make withdrawals during retirement tax-free, as long as you are 59 ½ and have held the account for five years or more.

Depending on your situation, the Roth 401(k) may have some advantages over traditional 401(k)s and Roth IRAs.

How Does a Roth 401(k) Compare to a Traditional 401(k)?

This chart below outlines the main differences between Roth 401(k) and traditional 401(k) contributions.

Is the Roth 401(k) for Me?

The Roth 401(k) may be for you if:

• You make too much to qualify for a Roth IRA. Roth 401(k) contributions are not subject to income limitations. Any Roth 401(k) participant may have unlimited income and still designate any or all of his salary deferral as a Roth 401(k) contribution. However, the non-discrimination tests on salary deferrals still apply. The Roth IRA limits are $150,000 for married taxpayers and $95,000 for single taxpayers.
• You think you'll be in a higher tax bracket in retirement. If you're in your 20s or 30s now, the odds of that are pretty good.
• You think tax rates may rise. The higher the tax rate upon contribution in comparison to a lower tax rate upon withdrawal, the greater the benefit from the traditional 401(k). The lower tax rate upon contribution in comparison to a higher forecasted tax rate in retirement creates more benefit from the Roth 401(k).
• You have estate planning needs. The Roth 401(k) and the traditional 401(k) both require mandatory distributions after the participant has reached the age of 70 ½.  The only difference is that you can rollover the Roth 401(k) into a Roth IRA once you retire. Since Roth IRAs have no rules requiring mandatory distribution after reaching age 70 ½, its funds could compound for 20-30 years without any funds having to be distributed from the account. This creates an opportunity to build up an inheritance for children or grandchildren. See your tax advisor for income tax versus estate/inheritance tax implications.

The Roth 401(k) may NOT be for you if:

• You are close to retirement. You may need to begin withdrawing designated Roth deferrals before they meet the 5-year holding period. This could be problematic if all of your monies in the 401(k) plan are Roth monies as your distributions will not be qualified distributions and will be subject to taxation.
• You are living paycheck to paycheck. With a Roth deferral, your paycheck will be a little smaller which could create a cash-flow problem for those living paycheck to paycheck.

Note: The Roth deferral causes your after-tax income to be higher, which could limit certain tax breaks such as the Child Tax Credit or the AMT exemption. If this applies, consider splitting your deferral between pre-tax and Roth deferrals. You should discuss any tax or legal matters with the appropriate professional.

How the Roth 401(k) Works

• You choose how much you defer. For example, you can designate 50% as a pre-tax traditional 401(k) deferral and 50% as the after-tax Roth deferral. Total deferrals into the 401(k) may not exceed $15,500 or $20,500 for those 50 or older by the end of the year.
• Your Roth deferrals are irrevocable. At the time you make your election to salary defer, you must designate the amount to be earmarked as a Roth 401(k) deferral. You can change the amount of future deferrals but, once the dollars are withheld from your pay, they must be treated as Roth deferrals from that point forward.
• Only your qualified distributions are tax and penalty-free. You can generally receive a distribution on severance of employment, plan termination, death, disability, attainment of age 59 ½ or hardship. To be considered a qualified distribution, the distribution must have been made after the expiration of the 5-year period beginning with the first tax year in which the participant first made a designated Roth deferral into the plan. For all other distributions, Roth IRA contributions are non-taxable, but earnings are taxable and subject to the 10% early distribution penalty.
• Your employer cannot contribute. The employer match and any non-elective, or profit-sharing contributions the employer puts into the plan may not be designated as Roth contributions. The employer may match the employee's Roth contribution, but the matching contribution will be on a pre-tax basis and will be taxable income to the participant when distributed. Similarly, forfeitures allocated to the participant may not be designated as Roth contributions.

If you have questions or need more information, contact Dale Beals at (615) 690-4052 or by e-mail at dale.beals@pnfp.com. Dale's office is located at Pinnacle Hendersonville, 270 E. Main St., Hendersonville, TN  37075.

Securities and investment advisory services offered through Raymond James Financial Services, Inc. Member NASD/SIPC NOT FDIC insured NOT GUARANTEED by Pinnacle National Bank Subject to risk and may lose value.

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