Tuesday, April 03, 2007

Roth 401(k) or Roth IRA?

In this article, we will take a look at two schemes - a Roth 401(k) and Roth IRA and see the pros/cons of both.

Wikipedia has a good description of Roth IRA. There is also a special provision where people not eligible to contribute to Roth IRA can contribute to IRA and then convert the assets to Roth IRA at a later date.

First some background on Roth IRA and IRA.

On August 17, 2006, President Bush signed into law the Pension Protection Act of 2006. This law made permanent increased contribution limits to IRAs (including Roth IRAs) that would otherwise have expired after 2010. It also made permanent the Roth 401(k), which would otherwise not have been available after 2010. For additional information, see the Roth 401(k) Web Site. On May 17, 2006, President Bush signed the Tax Increase Prevention and Reconciliation Act of 2005 into law. This tax bill included a provision dealing with conversions of traditional IRAs to Roth IRAs. Starting in 2010, the existing $100,000 income test for converting a traditional IRA to a Roth IRA will no longer apply. Conversions that occur in 2010 will be able to have half of the taxable converted amount taxed in 2011 and the other half taxed in 2012. For additional information, see the statutory provisions and the conference report.

IRA Taxation:When you take money out of an IRA, you pay income tax on all or part of it, depending on whether your original contributions were tax-deductible or not. If your contributions were taxdeductible (in other words, made from pre-tax income), you’ll pay income taxes on the entire withdrawal. If your contributions were not deductible (in other words, you used after-tax dollars,) you generally will be taxed on the earnings only at the time of withdrawal.

If you made both deductible and non-deductible contributions, then each IRA withdrawal is taxed in proportion to the mix of deductible and non-deductible contributions in all your IRAs. For more information on calculating the tax, see IRS Publication 590.

Contribution Limits:

Year Traditional/Roth
2006 $4,000
2007 $4,000
2008 $5,000
2009 $5,000

The Roth 401(k), is also permanent. Roth 401(k) is similar to Roth IRA except that the plan works as part of the 401(k) plan. One has to forego tax deduction now to participate in the Roth 401(k) plan. Also - one has to live with the limited investment options available in the 401(k) plan.

Is it possible to have the best of both worlds? The answer is yes, absolutely. One can contribute to the traditional IRA and convert it to Roth IRA in 2010. Meanwhile, one can continue contributing to 401(k), maxing out the contributions if possible.

In 2007, there is time till 17th of April to contribute to IRA. I am going to avail this opportunity to open an IRA account. I plan to convert this to traditional Roth IRA in 2010. Meanwhile, I participate in a regular 401(k) at work where I get matching contribution and tax savings.

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