Tax Advantages of Roth 401(k)

On December 11-12, 2010, The Wall Street Journal reported in “When It’s Time to Rothify Your 401(k)” that taxpayers are converting from a traditional 401(k) plan to a tax-free Roth 401(k) account.

The 401(k) plan is a tool for tax savings, retirement funding, and estate planning. Most 401(k) plans are funded by participants, with the company not paying any of the costs. In a 401(k) plan, the participants are normally responsible for their investment decisions. A plan administrator discloses in the summary plan description general plan expenses and investment information. For example, a company may engage an outside company to act as trustee. Typical trustees charge $250/quarter. The $250 comes from the participants in proportion to the funds they invest, with those investing more contributing more to the fees.

Traditional 401k Contributions Are Tax Free

In a traditional 401(k) plan, the contributions are tax-free, but the distributions are not. People aware of their paycheck deductions see that when they contribute to a traditional 401(k) plan, the paycheck deductions decrease their federal taxes.

Compared to traditional 401(k) accounts, the contributions to Roth 401(k) accounts are made after-tax, but growth and withdrawals are tax free. Though Roth 401(k) accounts are from after-tax contributions, the funds must all come from the employer’s payroll. Except for 401(k) rollovers, after-tax contributions does not mean people can take money from outside their paychecks such as a bank account or a source other than their earnings to put in the 401(k) plan.

Taxpayers who are high income may prefer to convert traditional 401(k) accounts to Roth. Many taxpayers have already converted from traditional IRA to Roth IRA. However, with 401(k) plans, it may not be as flexible to reverse back to a regular 401(k) once converted to a Roth 401(k) like in n IRA. Individuals may have second thoughts to convert back when the market changes.

A Roth IRA or 401(k) account allows people who do not need to use the money contributed to pass the funds to heirs with more tax savings. When an individual converts from a traditional 401(k) account to a Roth 401(k), full income taxes are due upon conversion. Roth 401(k) assets are in pension plans that have regulations that may differ to offer more creditor protection. For example, in a bankruptcy, the individual may need to list the retirement account in the personal assets schedule, but the retirement account may also be listed in the exempt property schedule, letting the individual keep the property after bankruptcy closing.

Federal and New York state tax laws may be complicated, engage an experienced New York tax attorney to maximize tax savings.