Some people work to live. I work to retire. I'm a fan of anything that's going to help me reach that goal faster.
Since I started investing 20 years ago, the two best paths to early retirement have been the 401(k) and the Roth IRA. A 401(k) lets you defer paying taxes on your savings until you withdraw the money in retirement, when your income tax rate is likely to be lower. If you think you'll be in a higher income bracket when you retire, or if you want to pass money to your heirs tax-free, you might choose a Roth IRA as well, paying the taxes now so that you can reap the gains tax-free in your golden years.
We optimists who believe we'll be richer in retirement love the Roth IRA. I contribute the maximum amount every year.
The problem? Some people make too much money to use a Roth IRA. Benefits phase out quickly for single people with adjusted gross incomes of more than $99,000 and married couples with incomes more than $156,000. In any case, the limit on contributions is just $5,000 for 2008 ($6,000 if you're 50 or older and "catching up").
Enter the Roth 401(k), introduced in 2006. It allows savers to contribute the full 401(k) limit of $15,500, regardless of their income. Those older than 50 can contribute an additional $5,000. And once they retire or reach 59 1/2, they won't owe a cent in taxes on their contributions or the accumulated gains. That's a powerful weapon in your retirement arsenal.Here are the highlights of the Roth 401(k):
- Contributions are made through payroll deductions, just as in normal 401(k)s.
- But contributions do not reduce your taxable income.
- Like traditional 401(k)s, redemptions from the account can start at 59 ½, or after retirement, which ever comes later.
- Required minimum distributions begin at 70 1/2, unless the money is rolled into a Roth IRA, which doesn't require minimum distributions and can pass to heirs.
- Any matching employer contributions are funneled into a traditional 401(k).
- You can split your contributions between traditional and Roth 401(k) accounts.
- But you can't move money between the different 401(k) types.
- Your employer decides which investment options are available to you (unlike a Roth IRA, in which you pick whatever you like).
A 40-year-old making $50,000 a year falls into the 25% federal income tax bracket. He contributes 10% of his salary, or $5,000, to a traditional 401(k). This 401(k) contribution reduces his taxable income to $45,000. In the 25% tax bracket, this amounts to tax of $11,250.
If that same person were to choose a Roth 401(k) instead, the 25% tax would be levied on the full $50,000 and the tax would be $12,500, an increase of $1,250.
The difference is even greater for those with higher salaries. Suppose a single filer making $90,000 a year contributed the maximum, $15,500, to a traditional 401(k). In the 28% bracket, her tax would be $20,860. But that same $15,500 contributed to a Roth 401(k) would leave her with a bill of $25,200, a difference of $4,340.