Back to Cover & Rossiter's Financial Tips

Now there is a Roth in Everyone's Future!

 October 2005

You have heard about ROTH IRAs, not only because they were created by the late Senator William Roth but because they have unique advantages. A ROTH IRA grows income tax free provided you do not withdraw funds in the first five years. Moreover, ROTH’s are not subject to the minimum distribution rules, allowing your funds to potentially grow tax free for generations.  Up until now, however, many taxpayers have been unable to take advantage of a ROTH due to the strict income limits ($110,000 for singles and $160,000 for joint filers).  Another restriction is the comparatively low contribution level of $4,000 per year.

Well, you are now in luck! Beginning on January 1, 2006, your company 401k can be upgraded to allow employees to contribute any portion of their before tax 401k limit of $15,000 (before catch up contributions) into an after tax ROTH IRA. Employees can now contribute to one or both of their pretax account or after tax ROTH IRA account. Employee matching contributions and profit sharing contributions must continue to go into the employees pre-tax 401k account. Education and not for profit employers that offer 403B plans can also add ROTH options to their plans.

From the corporate standpoint, I cannot foresee any downside to adding a ROTH component to your company 401k.  It is an added benefit for your employees at little or no additional cost to you. You need to revise your plan before year end in order to have the ROTH component in place on January 1, 2006.   We recommend that you start the process now.  

From the employee’s standpoint, they will then need to decide how much to put in each component of the 401k.  Computer models are busting out all over the internet claiming they can help you calculate the right combination by considering three factors:

• the trade off between the upfront tax deductions with the traditional 401k versus the nontaxable nature of the withdrawals from a ROTH IRA.  For instance, if you expect to be in a lower tax bracket in retirement, you should gladly accept the upfront tax savings of the regular 401k.
• how much of these funds will you need in retirement? ROTH 401Ks are subject to the same minimum distribution rules as regular 401ks, but you can roll the ROTH 401k funds over to a regular Roth IRA at retirement and avoid the minimum distribution rules. So to the extent you will not need these funds in retirement, it is a slam dunk to dedicate a substantial portion of funds to the ROTH 401k as they will grow into perpetuity. 
• what rate of return do you anticipate on your investment? The higher your investment return and the longer your investment horizon, the more you should be inclined to go the ROTH route.

While these calculations are fun math, I believe that they miss the point.  Can anyone be totally confident predicting the cash flow they will need in retirement or the returns they will earn on their investments?  I cannot even begin to tell you what the tax code will look like in 5 years no less 25 years.  A good compromise would be to dedicate my fixed income investments into the regular 401k and put the equity growth investments into the ROTH portion of my company plan.

This lunch byte was written by Diane Burke. Call (302-656-6632) or email her at Dburke@coverrossiter.com  for assistance in this or any financial planning matters.