Q: My company is offering both a traditional and a Roth 401(k) plan this year. Is a Roth 401(k) the same as a Roth IRA? Is it better than a traditional 401(k)?
A: A Roth 401(k) and Roth IRA are not the same. But their basic underlying concept is: You put money away for retirement with no tax deduction for your contributions. But when you retire, you withdraw contributions and earnings tax-free.
As much as we like easy answers, you can't say one type of 401(k) or IRA is better than the other without qualifications. The right choice depends on individual circumstances and involves tradeoffs.
In a traditional 401(k), the most common type, workers contribute a portion of their salary to an employer-sponsored plan. The employer may add a matching contribution. None of the contributions counts as taxable income, and all investment gains accumulate tax-deferred. When the money is withdrawn, everything is taxed as ordinary income. As with traditional IRAs, workers must generally start taking money out after age 70 and a half.
With a Roth 401(k), first made available in 2006 but still not as widely offered, employee contributions count as taxable income. But investment gains accumulate tax deferred and withdrawals of both employee contributions and investment gains can be tax-free in retirement.
In a Roth 401(k), however, any employer matching contributions are kept separate and get the same tax treatment as in traditional 401(k)s.
Unlike Roth IRAs, which never require the account holder to take money out, Roth 401(k)s impose mandatory withdrawals after age 70 and a half. But withdrawals can be avoided simply by rolling over a Roth 401(k) into a Roth IRA. Roth 401(k)s are open to all workers regardless of income, while Roth IRAs have an income ceiling.
Subject to each employer's rules, the most an employee can put in a traditional or Roth 401(k) plan (or in both plans combined) is $16,500 in 2009, plus, an additional $5,500 "catch-up" contribution for workers 50 and over, for a total of $22,000.
By comparison, IRAs are individual plans, not employer-sponsored, and contribution limits are lower. The maximum contribution for 2009 to a traditional or Roth IRA (or both combined) is $5,000, with an additional $1,000 "catch up" or $6,000 total for people 50 and over. You can contribute to an IRA and 401(k) the same year in any combination of traditional and Roth plans for which you qualify.
Now that we know all this, which type should we choose?
An analysis by William Urban, a certified financial planner and co-managing principal of Bingham, Osborn and Scarborough in San Francisco, indicates the Roth 401(k) "might be the better choice for more people than commonly understood."
The conventional wisdom is that a Roth 401(k), with tax-free withdrawals, makes more sense if you expect to be in a higher tax bracket in retirement. Urban's analysis shows that even if your tax bracket dips in retirement, the tax-free accumulation in the Roth may still make it a better deal.
That's particularly the case if you can afford to put in the maximum in a Roth 401(k) from early on in your career. Young workers are often in lower tax brackets, minimizing the immediate tax benefits of traditional 401(k)s. But they also may be living on tight budgets and be unable to contribute the maximum.
If unsure which one is best for you, and your employer offers both, you can split your contributions between a traditional and Roth 401(k) and/or change your selection each year, depending on your current tax bracket and circumstances.