Under the tax umbrella
Should I open a Roth 401(k) to shelter more of my retirement money from taxes? I make too much money to be eligible for a Roth IRA.
By Walter Updegrave, MONEY Magazine senior editor

NEW YORK (CNNMoney.com) - I currently max out my 401(k), but I make too much money to be eligible for a Roth IRA. I've read, however, that starting this year there's a Roth 401(k). I like the idea of doing the Roth because if tax rates go up after I retire, I can choose to pull money out of my Roth instead of my regular 401(k) and save myself some money on taxes. What do you think -- should I do the Roth?

-- Mark Newberry, Austin, Texas

First, let me say that I like the way you think. Most people are familiar with the idea of diversifying their investment portfolios by divvying up their money among different asset classes -- stocks, bonds and cash -- and even spreading around a bit more to include large and small stocks, growth and value, taxable and tax-exempt bonds and even high-yield corporates. The idea is to hedge a bit so your portfolio keeps chugging along even if one type of investment gets clobbered.

But many investors don't realize that the notion of hedging your exposure applies to taxes as well. If you have your entire retirement portfolio in a 401(k) or IRA rollover, then all your withdrawals (except for any after-tax contributions) are taxed at ordinary income rates, which these days are as high as 35 percent.

But if you have part of your nest egg in a Roth IRA or Roth 401(k), you don't get the tax break when you make the contributions -- but everything (your contributions as well as earnings) is tax-free when you pull it out in retirement. (For more on how the Roth 401(k) actually works, click here.)

Tax diversification

So by having some money in both pots -- one taxed as ordinary income, one not taxed at all -- you have a lot more flexibility in how much tax you pay on withdrawals during retirement. If, for example, you find that withdrawals from your 401(k) or IRA are about to push into a higher bracket, you can begin tapping your Roth.

In fact, I like taking this idea a step further and also having a pot of retirement investments that are taxed at long-term capital gains rates, which now max out at 15 percent. This pot would include investments such as stocks, mutual funds and ETFs that are worth more than you paid for them and that you've held longer than 12 months. This way, you've got three different tax pots from which you can draw, giving you even more wiggle room for increasing the after-tax size of your withdrawals.

I call this concept of hedging your tax exposure "tax diversification," and I've been pushing it for years. (To read more about tax diversification, click here.

If you have it, go for it

Unfortunately, however, this is one of those cases where a perfectly good strategy may run up against the shoals of hard reality -- the hard reality in this case being that employers aren't exactly jumping on the Roth 401(k) bandwagon.

Indeed, a recent survey of more than 220 large companies by benefits consulting firm Hewitt Associates found that only 13 percent of companies say they are very likely to add a Roth 401(k) this year.

Apparently, employers are worried that adding a Roth 401(k) might be a cumbersome administrative undertaking, plus they're concerned employees might not understand and use it. (Memo to employers: Many of your workers are a lot smarter than you think!).

If you're lucky enough to work for one of those enlightened employers who's already offering the Roth 401(k) or plans to, my advice is to direct at least a portion of your contribution to the Roth.

If your company doesn't provide access to a Roth 401(k), then by all means continue to contribute to your regular 401(k) -- and if you have additional money to invest after tax, you might try tax-managed funds, index funds and ETFs. (For more on these options, click here and here.

But don't be shy about asking your employer to consider adding the Roth as an option. As they say about taking your receipt after a cab ride in New York City, "it can't hurt, it might help!"


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