Monday, September 28, 2009

The Important Stuff YOU Need to Consider About Roth 401(K)s

The Important Stuff YOU Need to Consider About Roth 401(K)s

You probably already know that the Pension Protection Act of 2006 authorized employers to offer their employees a Roth 401(k) option, under Section 402(A) of the Internal Revenue Code. OK, enough technical language – now to my favorite, plain English.

As one would expect, there are those who think the Roth 401(k) is the greatest thing that happened to retirement savings in the 21st century, but there are also those who think otherwise.
Those who don’t like it argue that when people retire, their incomes generally decrease, hence they’re bound to be in lower tax brackets. Therefore, they argue, it is better to delay paying taxes, letting the money compound until retirement when you will pay less in taxes. However, if you really pay close attention (which most people don’t do until they are actually retired), this whole argument sounds crazy. It’s pretty much just a big joke! But to be fair, I feel obligated to state all points of view.

Here’s the thing. From what I have personally witnessed in my consultations with REAL people in this country, some of whom are already retired, although their total incomes usually decrease in retirement, their taxable incomes are not reduced enough to significantly alter their tax brackets. Actually, most of the already-retired who contact our firm do so because they’ve fallen prey to this bogus assertion and now need help so they can spend their retirement money – instead of paying it out in the form of taxes. I discuss this as Mistake #1 in my upcoming, easy-to-read book, 5 Mistakes Your Financial Advisor Is Making. Stay tuned – I’ll tell you how to get your FREE copy in the next couple of days.

Those who champion the Roth 401(k) argue that it’s better to make after-tax contributions so that you get to grow your money and withdraw it tax-free, on or after the date you turn age 59½, provided you’ve had the account for at least 5 years. When you die or become disabled (within the meaning of IRS Code Section 72(m)(7)), distributions are also tax-free. Yes, it sounds a bit technical, but that’s the language our government speaks.

Given our nation’s current fiscal climate, with its unprecedented budget deficits and incredible pressure on Social Security, Medicare, and Medicaid – increasing by the minute, as the baby boom generation nears retirement – tax rates are most likely headed up. Y’know, Uncle Sam must pay his bills, too. This is why I generally advocate not waiting to pay your taxes in the future, because one of the things you cannot lock in, no matter how you might want to, is tax rates. But if you and your advisor truly believe that tax rates will be coming down sometime soon, go ahead and knock yourself out with a traditional 401(k) plan.

You Cannot Convert a Regular 401(k) to a Roth 401(k)

Yes, even if you want to, the law does not allow the conversion of a regular 401(k) to a Roth 401(k). Wonder why? Could it possibly be that Uncle Sam understands very well why I caution people against these products? The majority of Americans – to their own amazement, and contrary to what most of their so-called financial advisors and accountants “promise” – stay in the same tax bracket (or move up to a higher one) during retirement, because their taxable incomes do not decrease enough while simultaneously, their exemptions and deductions are reduced. Interestingly enough, this is the nearly inevitable result of listening to the toxic retirement planning advice they received from the very same “experts” who promised them lower taxes.

Realize I said “taxable” income. Because this is drastically different from total income, which is what your advisor told you would be lower when you retire. And guess when you will have to start withdrawing the money from your traditional 401(k) to pay those deferred taxes? If you guessed as soon as you have few to no deductions and exemptions, we are on the same page.

Another thing, your employer’s matching contributions MUST be made only in a regular 401(k) format. This makes no sense to me, but again, it’s the law. While your money is going into a Roth 401(k), your employer’s match must go into a regular 401(k), which you decided you didn’t like in the first place – that’s why you switched to the Roth!

A Roth 401(k) also requires that once you attain the age of 70½, you begin making minimum withdrawals, just like you would with traditional plans.

What If You Could Enjoy the Benefits of a Roth 401(k) Without All the Strings?

Under existing IRS rules, there is a means by which you can make after-tax contributions to your own account and access it tax-free, including the gains accrued before age 59½ , without being obligated to repay it. And, you do not have to make any minimum withdrawals once you reach age 70½. Since money from the vehicle I am talking about is not considered earned, passive, or portfolio income under the Tax Reform Act of 1986, it does not affect taxation of Social Security benefits in any manner. It also allows you to transfer any remaining funds to your heirs, income-tax free upon death.

I can guess how you must be feeling right now. It’s kind of like that game board that’s covered with red (0r white) and black squares. You can decide to use it to play the game of checkers OR chess – the choice is up to you.

Give us a call at 301.949.4449 or visit to schedule your free consultation and let us help you understand ALL of your options.

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