This vehicle can lessen the impact of tax increases.
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By Christine Benz | 11-06-08 | 06:00 AM | Email Article

Although the market environment has brightened a bit recently, the past year has obviously been a challenging one for investors. Amid such a difficult climate, your best bet is always to focus on what you can control and tune out what you can't.

Christine Benz is Morningstar's director of personal finance and author of 30-Minute Money Solutions: A Step-by-Step Guide to Managing Your Finances and the Morningstar Guide to Mutual Funds: 5-Star Strategies for Success. Follow Christine on Twitter: @christine_benz.

In the category of what you can control--at least in part--are your investment costs, and that includes the tax costs associated with your portfolio. Not only does it pay to consider the current tax treatment of your investments, but it's also worthwhile to think about what tax rates and your own tax position might be like in the future. Because I think it's a good bet that tax rates will go up in the coming years--and I say this not because of the election but because of the staggering demands on our government's coffers--it makes sense to brace your portfolio for that possibility.  

Roth IRAs, to which you contribute aftertax dollars but enjoy tax-free withdrawals, are one way to hedge against the possibility of higher taxes. Roth 401(k)s, which are growing in popularity, also allow you to take the tax hit now rather than later. If you fit the profile of someone who could benefit from a Roth 401(k), you owe it to yourself to understand how this vehicle works and whether it could make sense for you.

The Basics
If you're familiar with how a Roth IRA works, it's easy to get your arms around how a Roth 401(k) operates. As is the case with a Roth IRA, you'll contribute aftertax dollars to a Roth 401(k). The trade-off for taking the tax hit sooner rather than later is that you'll be able to withdraw your contributions and any earnings without having to pay taxes.

That's just the opposite of the tax treatment your standard 401(k) contributions and withdrawals receive. You invest pretax dollars in a conventional 401(k) and therefore have more investment dollars working for you from the get-go, but you'll pay income tax on your withdrawals.

Other than the basic differences in tax treatment, Roth 401(k)s are quite similar to standard 401(k)s, and most companies that offer the Roth option will probably offer the Roth and standard 401(k) in tandem. (Educational and charitable institutions that currently offer 403(b)s will also be able to add a Roth option to their plans.)

There's no income limitation governing who can contribute to either type of account, and the same contribution limits that apply to a standard 401(k) will also apply to a Roth 401(k). In 2008, you can contribute $15,500, plus an additional $5,000 if you're over age 50. That limit applies to your total contributions to both accounts; that is, you won't be able to contribute $15,500 to a Roth 401(k) and another $15,500 to a standard 401(k). Because you're putting aftertax dollars into the Roth, however, your effective contribution rate is much higher than it is for the standard 401(k). That's partly why I'm so bullish on the Roth 401(k) as an option for higher-income savers who are maxing out their contributions to tax-sheltered vehicles or those who earn too much to contribute to a Roth IRA. (More on this below.) 

Once you've told your employer or 401(k) plan administrator whether you want your investment dollars to go to the standard 401(k) or to the Roth 401(k) (and you may have the option to send part of each contribution to each vehicle), you'll be able to allocate your investment dollars among a menu of investment choices, most likely mutual funds. Finally, you can't withdraw your investment earnings on a tax-free basis until you reach age 59 1/2, and you'll be required to begin taking distributions from the Roth 401(k) when you're age 70 1/2, just as you have to do with a standard 401(k) plan.

Who Should Consider It
Why would you rather pay taxes immediately, as you're required to do with a Roth 401(k), instead of deferring the taxes into the future, as is the setup with a standard 401(k)? One good reason, as I noted earlier, is that taxes across the board may well be higher in the future than they are now. Getting the country out of an economic ditch is proving costly, of course, and the Economic Growth and Tax Relief Reconciliation Act of 2001 had some pretty generous provisions, many of which are set to expire in 2010. If taxes are poised to go up, you're better off taking the tax hit now than you are later, when taxes are higher.

Moreover, your own profile could make the Roth 401(k) preferable to a traditional 401(k). If you expect to be in a higher tax bracket when you retire than you are right now, it's obviously better to pay tax on that money at your current lower rate than it is to pay taxes when you're in a higher income bracket in the future.

Of course, I'll be the first to concede that it's difficult to forecast your future income, particularly if retirement is 10 or more years off. But if you're just starting out in your career and expect your earnings to ramp up rapidly in the future, you may be better off contributing to the Roth 401(k) and taking the tax hit now than you are paying taxes on withdrawals from a standard 401(k) when you're in a higher income-tax bracket down the road. And if you have a long time horizon until retirement, the Roth 401(k) could also be preferable to a standard 401(k) because you won't be taxed on your investment earnings, which may grow to be an impressive sum over time.

Although a Roth 401(k) may well make sense for you if you're just starting out, it's probably an even better bet if you're further along in your career and pulling down a substantial salary; perhaps you've been funding your standard 401(k) plan up to the limit, but you earn too much to contribute to a Roth IRA. (If your income exceeds a certain threshold--in 2008, that threshold is more than $116,000 if you're single and more than $169,000 if you're part of a couple who files jointly--you cannot contribute to a Roth IRA.) If that's the case, you'll probably find it beneficial to take advantage of the Roth 401(k) and the tax-free withdrawals that these plans afford. Even if you have no idea whether your income level and tax bracket in retirement will be higher or lower than they are now, the Roth 401(k) provides a good opportunity to hedge your bets: You'll pay some taxes now (on the Roth 401(k)) and some later (on the money you withdraw from your standard 401(k) plan).

What to Watch Out For
So, you're wondering, where do I sign up? Not so fast. The Roth 401(k) is apt to be appropriate for savers in many situations, but it's not for everyone. In particular, employees who don't expect to stash away a substantial sum for retirement (and unfortunately, many people fall into that category) will almost certainly be better off in a standard 401(k), as their income levels in retirement are apt to be lower than they were in their working years. And while your contributions to a conventional 401(k) reduce your taxable income on a dollar-for-dollar basis, that's not the case for the Roth 401(k). That means that if you divert new contributions to a Roth, and thereby have a higher taxable income, you may no longer qualify for some credits and deductions that you were eligible for in the past.

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Morningstar - 2008/11/06 - Is the Roth 401(k) Right for You? - <a href="http://www.morningstar.com/articles/author/30-christine-benz.aspx">Christine Benz</a>
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