Question: If I have a 401(k) plan, do I need a Roth IRA?
Answer: Contribute enough to your 401(k) to capture your employer's matching contribution, then switch to a Roth IRA. The annual contribution limits for a Roth are relatively low — $4,000 in 2006, or $5,000 for workers 50 and older — and not everyone is eligible. You can't contribute to a Roth if you're single and your income exceeds $110,000 or if you're married with a joint income of more than $160,000. But if you qualify, the Roth IRA is probably the best all-around retirement plan there is — and certainly the most flexible. Four reasons the Roth IRA rocks:
You can stockpile savings that are tax-free when you start making withdrawals in retirement.
You can withdraw your contributions at any time, without paying taxes or a penalty. That's because you don't get an up-front tax deduction for your contributions, as you do with a traditional IRA.
You get generous escape hatches that let you withdraw your earnings to pay for major expenses, such as a first home or college. After your account has been open for at least five years, you can withdraw $10,000 in earnings tax- and penalty-free to buy a first home. And you can withdraw earnings penalty-free to pay for college expenses.
You get estate-planning advantages. Unlike traditional IRAs, Roths don't require distributions. And your heirs can inherit a Roth IRA tax-free.
Question: My employer offers the new Roth 401(k). Is it right for me?
Answer: A Roth 401(k) offers all the tax-free advantages of a Roth IRA but with the higher contribution limits of a 401(k) — $15,000 for most workers and $20,000 for those 50 and older this year. And there are no income limits. So if you are shut out of funding a Roth IRA because you make too much money, this could be your opportunity to build up a stash of tax-free income for retirement.
The downside is that you don't get a tax deduction for contributing to a Roth 401(k), so switching could mean a big tax hit. In the 28 percent bracket, for example, you'd owe $5,600 in taxes on a $20,000 contribution. And your take-home pay would be reduced compared with the same contribution to a traditional 401(k) plan.
There's no predicting what tax rates will be when you stop working, so the prospect of tax-free income in retirement is a good way to diversify your savings. One strategy is to split your contributions between the two types of 401(k) plans (as long as your combined contribution doesn't exceed the annual maximum). That way, you can preserve some of your tax deductions and accumulate tax-free income for the future.