As another year zips by, you are a year closer to retirement. Even though that day may still be a long time away, it will eventually arrive—so you’ll need to prepare for it. Will you sell your business and use some of the income from it in retirement, or will you stay on as a consultant and continue to receive pay for your services? Both are smart choices; however, they still represent taxable income. This is taxable income that most in the electrical industry want to avoid. Recently one more retirement savings vehicle has been added—the Roth 401(k).
Just like a regular 401(k), a Roth 401(k) allows you to spread your money among a variety of investments. But there are differences between the two types of 401(k) plans. When you invest in a traditional 401(k), you generally contribute “pre-tax” dollars, which means you are not taxed on your contributions today. These contributions and your earnings will be taxed when you withdraw them at retirement. Using the Roth feature in your 401(k) allows you to contribute “after-tax” dollars, which means you pay taxes on your contributions right away. However, your withdrawals and earnings will be tax-free (provided you’re at least 59 1/2 and you’ve had the account for at least five years when you retire).
Furthermore, if you leave your job, you can roll over the Roth portion of your 401(k) into a Roth IRA — and Roth IRAs don’t force you to take required minimum distributions after you turn 70 1/2, which could be a big advantage if you won’t need the money until later in your retirement years.
And here’s one more advantage of the Roth 401(k): There are no income restrictions attached to it.
I have written several times about electrical contractors and inspectors that own their own company and have had many problems with the 401k in the past when it comes to the top-heavy testing. Of course, top-heavy means they are putting away a much larger contribution than their average employee is, and Uncle Sam sends them a nice check in the mail for their money back because they failed the discrimination testing. The Roth 401k is also available in the Safe Harbor 401(k), an alternative to the 401(k), which allows business owners to contribute a lion’s share of the contribution.
Of course, you may not even choose to offer the new Roth feature in your company’s 401(k). But if it is available, shouldn’t you offer it to your employees? Before deciding, consider these factors:
- Your age— The younger you are, the more advantageous it may be to contribute some of your 401(k) dollars into the Roth portion of your plan. As a young worker, you’ll have more years to take advantage of the tax-free earnings potential provided by the Roth feature. This additional time helps compensate for the cost of having to fund your plan with after-tax dollars.
- Your tax bracket at retirement— Most contractors feel they will be in a higher tax bracket when they sell their business and start taking income. If you expect to be in a high tax bracket when you retire, you may find the Roth 401(k) to be particularly appropriate. The value of being able to withdraw tax-free is worth more if you’re in a high tax bracket.
- Your willingness to divide 401(k) dollars between “pre-tax” and Roth— Your total 401(k) contributions, from all sources, are limited to $15,500 in 2007 (or $20,500 if you’re 50 or older). You could choose to put all $15,500 into either the pre-tax portion of your 401(k) or the Roth (after-tax) portion. You could also divide the $15,500, in any ratio you choose, between the two portions. For example, you could defer $7,750 into the pre-tax portion and $7,750 into the Roth portion.
Before investing in the new Roth feature of your 401(k), you may want to consult with your tax advisor and investment professional. You might only have a few years in which to take advantage of the Roth 401(k), because it will cease to be offered in 2010, unless Congress acts before then to make it a permanent fixture of the retirement planning landscape.
As long as it is around, though, the Roth 401(k) is going to be a valuable retirement savings vehicle — so think about putting it to work for you.