Consider the advantages of the Roth 401(k)

Transcription

1 Consider the advantages of the Roth 401(k)

2 Your plan offers a way of saving for retirement known as the Roth 401(k). What is it? It s a way to get your money tax-free in retirement. You can make tax-free withdrawals of your contributions and any earnings provided you are at least age and made your first Roth contribution at least five years prior. That could be a significant advantage over pre-tax contributions, whose withdrawals are currently taxed at 10% to 35%, depending on your federal income tax bracket.

3 Maybe you re wondering, What s the catch? Well, unlike pre-tax contributions, Roth contributions are made with after-tax dollars. So you d pay more in taxes today. But that could be a price worth paying if it means more money in retirement. Example: Sophia and Fred each contribute $3,600 a year to a retirement plan, and they both earn 6% annually on their investments. But Sophia makes pre-tax contributions while Fred makes Roth after-tax contributions. (That means Fred s contributions are taxed as regular income before being added to his account.) After 30 years each has $284,609 for retirement. However, Sophia will owe taxes on her withdrawals. Fred s withdrawals will be tax-free.* $300,000 $200,000 $284,609 $284,609 Tax owed** $100,000 $0 Fred Sophia This hypothetical illustration does not represent any particular investment. *Fred paid $16,200 in taxes on contributions over 30 years, assuming a 15% tax bracket. All references to taxes are federal taxes only. Individual state tax laws may vary. **The amount of taxes owed will depend on the tax rate at the time of the distribution and the amount withdrawn. Roth 401(k) > 1

4 Pay taxes today? Or later? So should you pay taxes today by making Roth contributions to your plan or stick with pre-tax contributions, where you postpone paying taxes today but owe them in retirement? As always, it depends. If you think your tax rate will be lower in retirement, it may be better to stick with pre-tax contributions. That way you ll postpone paying taxes until retirement, when you may be in a lower bracket. If you think your tax rate will be the same or higher in retirement, it may be better to go with Roth contributions. That way you ll pay taxes at a lower rate today. Of course, you don t have a crystal ball to tell you what your tax rate will be in retirement. It depends on so many things your income, family status, retirement benefits and even government tax policy. 2

5 The answer: Tax diversification What can you do in the face of this uncertainty? Consider doing what you already do when dealing with investment uncertainty: Diversify. Consider holding both pre-tax and after-tax savings in your retirement account. That s known as tax diversification. Pursuing a strategy of tax diversification could be a wise choice for many participants. That said, there are certain situations where it can be an especially good idea and some cases where it can make less sense. If you are financially well-prepared for retirement, Roth contributions may make sense. Strong savers and those with generous retirement benefits may have a sizable retirement income and be subject to sizable taxes. Having Roth savings exempt from taxation would be a boon. If you re not as well-prepared for retirement as you d like, pre-tax contributions may make sense. Your income and tax rate may drop in retirement. By making pre-tax contributions, you ll avoid paying taxes at a higher rate today and pay them at a potentially lower rate in retirement. Roth 401(k) > 3

6 Who might benefit from Roth contributions Who You re financially wellfixed for retirement (high savings, good benefits). You contribute the maximum to the 401(k).* Your income prevents you from contributing to a Roth IRA.** You don t earn a lot today but just wait. You pay taxes at a low rate today (10% or 15%). Why Chances are you ll be in the same or a higher tax bracket in retirement. Any Roth savings would be exempt from taxation. Switching to Roth contributions increases your tax-advantaged saving. For example, if you contribute $16,500 on a pre-tax basis, you will owe taxes on this amount, plus any earnings, in retirement. Contribute $16,500 on a Roth basis instead, and all of it will be tax-free in retirement. You can obtain the advantages of a Roth within your 401(k), which has no income restrictions comparable to those of the Roth IRA. Your career is just getting started. You expect your income and tax rate to rise in the years to come. Making Roth 401(k) contributions would cost you little today and could result in tax savings in retirement. *The maximum 401(k) contribution is $16,500 annually in 2010, or $22,000 if you re age 50 or older and your plan allows catch-up contributions. The limits apply to the total of all 401(k) contributions, whether pre-tax, Roth, or a combination. **To contribute to a Roth IRA, your modified adjusted gross income cannot exceed $177,000 for married taxpayers filing jointly or $120,000 for single filers in

7 Who might not benefit Who You re behind on saving and expect Social Security to be the mainstay of your retirement. Your pay spikes thanks to big commissions or bonuses. You have children, a family income generally between $20,000 and $50,000, and you receive the earned income tax credit or the additional child tax credit. Why Chances are your income will fall in retirement. Consequently, you ll be in a lower tax bracket. Your tax rate may be higher this year than in retirement. So you may be better off deferring taxes now with pre-tax contributions and paying at a lower rate later. If you switch to Roth contributions, it would raise your taxable income and could cost you these valuable tax credits. These credits are more valuable than Roth would be to you. Roth 401(k) > 5

8 The cost of Roth contributions Whether you are already enrolled in your plan or just ready to join, you can designate all, some, or none of your contributions as Roth. If you re already making pre-tax contributions, it s important to remember that your takehome pay will decrease if you switch any of your contributions to Roth. That s because more of your income will be subject to income taxes today. Example: John is in the 15% tax bracket and saves $3,000 a year to his 401(k). If he were to switch to Roth contributions, John would pay $450 more in taxes annually ($3,000 x 0.15 = $450). John is paid biweekly, so each check would be reduced by $17.31 ($ = $17.31).* *All references to taxes are federal taxes only. Individual state tax laws may vary. You could also reduce your contribution rate so that your tax bill stays the same, of course. But that s a strategy you may want to avoid, especially if it means that you might forfeit employer matching contributions. 6

9 Roth contributions could change your take-home pay For an idea of how Roth contributions might change your take-home pay, find the figure closest to your total household income and contribution percentages in the table below. The dollar figure at the intersection of the two factors is the reduction in pay that you might experience on a biweekly basis (26 pay periods per year) to pay income taxes on Roth contributions. The Roth paycheck effect Total household income Contribution 3% 6% 9% 12% 15% $25,000 $3 $6 $9 $12 $14 $50,000 $9 $17 $26 $35 $43 $75,000 $13 $26 $39 $52 $65 $100,000 $29 $58 $87 $115 $144 Assumptions: Estimates are rounded to the nearest whole dollar and are based on the IRS s Percentage Method Income Tax Withholding with two exemption allowances. Your withholding could also be affected by any other pre-tax deductions you have such as those for health benefits. Roth 401(k) > 7

10 A final note on Roth costs Switching to Roth contributions causes your taxable income to increase. This could reduce your eligibility for various tax credits and deductions, such as those for children and day care expenses, education costs, and the phaseout of deductions and exemptions for higher-income households. Before you switch to Roth contributions, it pays to check your tax return (or ask your tax preparer) to see what deductions or credits might be lower or eliminated. Most of these credits and deductions (except for the earned income tax credit or the additional child tax credit) phase out gradually. That said, the impact could be large or small depending on your situation. > How to get started Signing up for Roth contributions is easy. Call a Vanguard Participant Services associate at Monday through Friday from 8:30 a.m. to 9 p.m., Eastern time. Or log on to your account at Vanguard.com. Not sure you want to commit all your contributions to Roth? You can increase your contribution rate and dedicate that increase to Roth. Or you can switch just part of your current contributions to Roth. 8

11 Roth questions and answers What are Roth contributions? Roth contributions allow retirement plan participants to save on an after-tax basis. You get no current-year tax deduction for your Roth contributions. However, you can withdraw your contributions and their earnings tax-free if you meet certain conditions. What are the conditions for tax-free withdrawals? In general, to make a qualified tax- and penalty-free withdrawal of Roth contributions and earnings, the account must have been established for at least five years and the withdrawal must meet one of the following conditions: Be taken at or after age Be as a result of permanent disability or death. If a participant dies, the participant s fiveyear period carries over to his or her beneficiary. Once the five-year period is satisfied, distributions to the beneficiary will be taxfree. Distributions prior to such time will be considered nonqualified. When does the five-year period begin? It begins on January 1 of the year you make your first Roth contribution, which can be made at any time during a calendar year. Even if you contribute in December, you Roth 401(k) > 9

12 will still receive a year s credit. Also, you don t have to make a contribution every year. Your first contribution starts the clock. What if a withdrawal doesn t meet these conditions? Withdrawals that do not meet these conditions are considered nonqualified withdrawals. Nonqualified withdrawals are treated as a pro rata return of Roth contributions and earnings. The portion of the distribution that represents earnings will be subject to ordinary income tax and possibly a 10% federal penalty tax for premature distributions. However, the portion of the withdrawal that represents a return of Roth contributions would not be subject to tax. Are Roth contributions subject to IRA contribution limits? No. In 2010 you can make up to $16,500 in Roth contributions, plus an additional $5,500 if you re age 50 or older at any time during the year and your plan permits catch-up contributions. (Plan rules apply; your plan may have a lower limit.) The numbers reflect your total 401(k) contributions, whether pre-tax, Roth, or a combination. 10

13 If I make Roth contributions, can I still contribute to a Roth IRA? Yes, as long as you meet the income limits for a Roth IRA. To contribute to a Roth IRA for tax year 2010, your modified adjusted gross income cannot exceed $177,000 for married taxpayers filing jointly or $120,000 for single filers. Be aware that switching to Roth contributions may push you above the qualifying income limits for a Roth IRA. Will my employer match my Roth contributions? Your employer may match Roth contributions; however, the match would be on a pre-tax (not Roth after-tax) basis. This Roth 401(k) > 11

14 means you would owe income taxes on the matching funds and their earnings at withdrawal. If you withdraw them prematurely (generally before age ), you might owe an additional 10% federal penalty tax on the match and its earnings. Can I convert my pre-tax 401(k) balance to Roth? Potentially. Assets that you hold in your employer-sponsored plan are available for conversion to a Roth IRA if you re no longer eligible to contribute to the plan. Some plans may also allow conversion of plan assets to a Roth IRA for participants age or older. Be aware that pre-tax money converted to a Roth IRA will be taxed at ordinary income tax rates. We recommend that you consult a tax advisor about whether converting pre-tax assets to a Roth IRA may be right for you. Do I have to take required minimum distributions (RMDs) from my Roth 401(k)? Yes, you have to take RMDs after age But you can avoid them by rolling your Roth 401(k) money to a Roth IRA after you have left your employer-sponsored plan. In most cases, you do not have to take RMDs from plan assets if you are still employed at the company where you have your plan assets. 12

15 Where can I get more information? To learn more about Roth contributions, including enrollment information for your plan, go to Vanguard.com or call Vanguard Participant Services at Vanguard is one of the world s largest investment management companies, serving individual investors, institutions, employersponsored retirement plans, and financial professionals. We offer investors an exceptional value through a dedication to outstanding performance, helpful service, and low costs.

16 Vanguard Participant Services P.O. Box 2900 Valley Forge, PA Connect with Vanguard retirementplans.vanguard.com > MoneyWhys Library We recommend that you consult a tax or financial advisor about your situation. All investing is subject to risk The Vanguard Group, Inc. All rights reserved