NEW YORK (CNN/Money) -
Starting in 2006, the law will allow employers to offer a new option in 401(k) plans: to contribute after-tax money that will grow tax-free.
Currently, your 401(k) contributions are pre-tax, meaning you get a deduction the year you make the contribution, and you pay income taxes on your contributions plus earnings when you retire.
The new option is called a Roth 401(k) -- or a Roth 403(b) if you work for a non-profit. It's not a separate plan from your existing 401(k), but rather a new element to it.
So you will be asked first how much of your gross income you'd like to contribute to your retirement plan -- say, 15 percent. And then of that, you'll indicate how much you'd like to put in the pre-tax portion of the plan and the after-tax portion – say, 7.5 percent in each.
The new element is similar to a Roth IRA, which also lets savers invest after-tax money that grows tax-free. But it differs in significant ways.
What to consider before contributing after-tax money
- There's no income limitation: If your modified adjusted gross income is more than $95,000 (if single) or $150,000 (if married) you are not eligible to contribute to a Roth IRA. With a Roth 401(k), plan participants at all income levels are eligible to make contributions.
- Contribution limits differ: In 2006, you'll be able to put $4,000 into a Roth IRA plus a catch-up contribution of $1,000 if you're at least 50. But in your 401(k) you may contribute up to $15,000 plus $5,000 catch-up. Both your pre-tax and Roth after-tax contributions would be counted toward that. (Some plans already allow for after-tax contributions if you max out your regular 401(k) contributions, but that option is governed by different regulations and does not count toward the $15,000 limit.)
- Withdrawal rules differ: With a Roth IRA you may take your earnings out tax-free and penalty-free after five years if you use them for the purchase of a first home. You may take them out penalty-free for qualified educational expenses. In a Roth 401(k), you can't withdraw earnings tax-free or penalty-free until you're 59-1/2 and have had the money invested for at least five years.
The advantage of a Roth 401(k) is that when you retire, all the money in that part of your 401(k) will be yours in full. By contrast, any money in the pre-tax part of your account will be subject to income tax.
So, let's say you'll be in the 25 percent tax bracket in retirement. A $100,000 withdrawal from a Roth 401(k) equals $100,000 in your pocket. A $100,000 withdrawal from a 401(k) represents about $86,000 in your pocket after federal taxes, assuming you're married, taking the standard deduction and only one spouse is over 65.
You'd have less if you also have to pay state and local income tax, or if both spouses are under 65, according to enrolled agent and certified financial planner Chris Cooper.
That's why it's often said that a Roth-style investment makes the most sense if you're in a lower tax bracket today than you expect to be in when you retire, which is especially true for younger workers. (You pay less tax on the contribution now than you would paying tax on it in retirement. Plus, your earnings grow tax-free.)
But you have to weigh that tax-free withdrawal advantage against the effects of Roth 401(k) contributions on your present-day finances, said Wayne Bogosian, president of the Personal Financial Education Group.
For starters, if your employer won't match your Roth 401(k) contributions the same way they do your regular 401(k) contributions, make sure you contribute enough pre-tax to qualify for the full match.
Secondly, it's much easier to accumulate more in a pre-tax 401(k) than in a Roth-style 401(k), and that can even out the amount you pocket in retirement between your before-tax and after-tax withdrawals, Cooper said.
Say you decide to contribute $10,000 of your gross to retirement savings, and you'll split it between the pre- and after-tax portions of your 401(k). A full $5,000 is invested in the pre-tax side, but you may only be able to invest $3,500 in the after-tax side since that's the equivalent of $5,000 before tax.
Lastly, 401(k) contributions reduce your taxable income dollar for dollar. But Roth 401(k) contributions don't. Consequently, you may see less in your paycheck and you also could lose out on some key tax breaks.
According to enrolled agent David Mellem of Ashwaubenon Tax Professionals in Wisconsin, a single person making $60,000 could see his paycheck reduced by $15 a week for every $1,000 he diverts from his traditional 401(k) to a Roth version.
In addition, if that person has student loans, Mellem said, his higher taxable income would cause him to forfeit $17 in interest deductions for every $1,000 switched into the Roth.
Someone married with two kids and a household income of $111,000 would also take a $15 per week cut in take-home pay and lose out on some of the childcare tax credit -- $50 for every $1,000 switched into a Roth.
How are you going to know how a Roth 401(k) contribution will affect your ability to take credits, deductions and exemptions (all of which have different income restrictions)?
Chances are you're going to have to consult a tax professional before signing up.