A few years ago, my wife’s employer started to offer Roth 401(K) together with the traditional, pre-tax 401(K) plan. At that time we decided to continue funding the pre-tax 401(K) account and not contribute to the Roth account for the same reason I used to not covert existing Traditional IRA accounts into Roth. As you know, the biggest difference between a Roth 401(K) account and a Traditional 401(K) account is the former is funded with after-tax money while the latter is usually pre-tax up to a limit set by the IRA (the contribution limit for 401(K) is $17,500 in 2013). This means that, like Roth IRA, earnings in Roth 401(K) will also be tax free, as long as the distribution is made at least 5 years after the first contribution and the owner of the account is at least 59.5 years old.

The biggest advantage of a Roth 401(K) is that earnings will not be taxed, which is also precisely the reason I decided to convert our new Traditional IRA accounts into Roth. But what has prevented us from contributing to Roth 401(K) when it became available was the consideration of whether to pay taxes now or in the future. This is not an issue when choosing between Traditional IRA and Roth IRA because we can only make after-tax contributions. It makes no difference on our current tax situation whether to Traditional or to Roth. However, since earnings in Roth IRA are also not taxed in the future either, the choice is quite obvious. In the case of Roth and Traditional 401(K), tax comes into play as the former is post-tax and the latter is pre-tax. By contributing into pre-tax 401(K) plans, we can lower our current Adjusted Gross Income (AGI) by $35,000 per year if we max out, which we will do, and that will in turn reduce our tax liability. If on the other hand, we choose Roth 401(K), then our tax bill will go up. Even though the increased income may not be enough to push us into the next tax bracket, we will pay more taxes now for sure, in exchange for not paying taxes late in the future. The debate is whether to pay taxes now or in the future.

There’s obviously no way for us to know what the tax rates will be likely 20 or 30 years from now, so our deliberation was based entirely on assumptions. As I mentioned earlier, at the time when we retire, our sources of income will mainly come from 1) Social Security; 2) 401(K)s; 3) IRAs; and 4) other savings in non-retirement accounts. Except distributions from Roth IRAs, which accounts for only a small portion of our retirement savings, distributions from other sources will be taxed as regular income later. Even though we have been saving quite aggressively, my guess is that when we retire, our income will be lower than our salaries, which, hopefully, will continue to grow as long as we work. If this will be the case, then it makes sense to defer paying taxes to a later time by contributing pre-tax dollars to Traditional 401(K), especially that now we are able to fund Roth IRAs.

While the consideration of taxes is valid for us, Roth 401(K) is still quite attractive for 1) tax free distributions will give us more flexibility in the future (after-tax dollars are better than pre-tax dollars?); 2) Roth 401(K) can be rolled over into Roth IRA upon termination of employment, but not the Traditional 401(K).
This year, my employer switched from its self-managed 401(K) plan to the plan managed by Fidelity and one new feature came with the switch is Roth 401(K). As a part of the changes I made in 2013 on how we invest, I decided to also contribute to Roth 401(K). I didn’t make the full switch from Traditional to Roth 401(K), but only a third of the total amount allowed this year. That will exceed the Roth IRA limit. By participating in both Roth and Traditional 401(K), I won’t increase our taxable income too much now and get the benefit of tax free distributions in the future.

Are you also using Roth 401(K)? Yes or no, what are your reasons of using or not using it?

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If you are a participant of an employer sponsored retirement plan, such a 401(K) plan, then there’s a good news for you to save more for your future retirement. Starting next January, you will be able to put $500 more into the plan than what you can contribute this year.

The IRS announced yesterday that for 2013 the tax-free contribution limit to 401(K) plans will be increased to $17,500, up $500 from the current limit for 2012. For employees age 50 and older, the catch-up contribution limit, however, will remain the same as this year at $5,500.

For us, we have contributed to the maximum amount allowed in our 401(K) plans for years because the benefits of doing so are for both the future and the present. For the future, since neither of us has a pension and what is going to happen to Social Security is such much unclear, putting money in retirement savings accounts, such as 401(K) and IRA accounts, is the only way for us to prepare for our retirements in the future. As for the present, the benefit is that the tax-free contributions to 401(K) plans lower our current tax bills, translating to saving us money right now. Therefore, whenever circumstance allowed, both of us contributed close to the limit as soon as possible early in the year and only left a small portion for the rest of the year in order to get the employer matches because there will be no match if there’s no contribution.

Since the Pension Protection Act became law in 2006 allows employers to automatically enroll their new employees into 401(K) plans, there are studies showed that plan participants have increased, even when the default contribution rates for many employers were set to 3 – 5%. With that automatic contribution rates, workers might not be able to take full advantage of the tax-free contribution limit, but I still think it was a good starting point to at least get them some free money from their employers’ match contributions.

Of course, with employer sponsored defined contribution plans like 401(K), we usually don’t have the luxury of choosing how to invest the money since the investment choices are limited by the plan sponsor. Even in that case, it’s still important to pay a closer attention to how much some of the investment options cost in the long term. Early, I have discussed a free 401(K) fee analyzer from Personal Capital. Though the tool is not perfect as I mentioned in the post, it still can give you an idea on how much you pay in fees (such as mutual fund expenses and other administrative fees). If you are paying too much for your current investment selections, may be you can see if your plan offers other alternatives to lower your overall costs.

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If you are thinking of putting aside a little more for your retirement in 2010, you won’t get any help from the government because the 2010 401(k) contribution limit will remain at the same level as 2009 at $16,500 (the catch-up limit for workers 50 years old and order will also be the same as in 2009, at $5,500).

The reason for keeping the contribution limit steady for another year is that, according to Labor Department’s latest inflation report released on Thursday, Consumer Price Index (CPI) fell in the third quarter from the same period last year. Because there’s no inflation (at least as the CPI number shows), the annual contribution of 401(k) plan, as well as Social Security benefit, which is tied to the inflation, won’t be adjusted.

This isn’t the first time when the government maintained the maximum contribution of retirement plan unchanged. For example, the limit remained at the same level of $15,500 for 2007 and 2008. The maximum amount was adjusted every two years between 1994 and 2001.

While it makes sense to adjust the contribution limit based on the inflation, there are man people believe that CPI isn’t a good gauge for real inflation because goods that we consume every day, such as food and energy, are excluded from the calculation (the so-called core CPI) because they are volatile. Even though we spend a much smaller portion of our income on food nowadays than when CPI was first measured 90 years ago (the Labor Department started the statistics in 1919), food does become expensive year over year and the costs to fill up our cars and heat our homes also get higher and higher. Further more, since the Fed makes their rate decision based on core CPI, a low reading means the Fed can keep the interest rate low, which will lead to greater inflation risk, especially when the index doesn’t track the increase of  cost of living quick enough.

Meanwhile, the 2010 IRA contribution limit will also remain the same as last year at $5,000, whether it’s a traditional IRA or Roth IRA, due to the same reason (learn more about 2010 Roth IRA conversion).

Now that there won’t be any increase in contribution limit next year, it doesn’t seem to be a big deal for one year. However, it is a big deal in the long term for those who max out their contribution every year. Just consider this: How much will today’s $500 be worth 20 or 30 years from now?

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Don’t borrow money from your 401(k) account unless you absolutely have to. If you have to, pay it back as soon as possible.

The Securities and Exchange Commission (SEC) last week issued a warning on using 401(k) debit card to tap into retirement funds to pay for daily living expenses. As the slowed economy put the squeeze on people’s wallets, more and more turn to their retirement savings to pay their mortgages, medical bills, and daily expenses, and a 401(k) debit card just makes the borrowing process a lot easier. While there’s nothing wrong if you have to take a 401(k) loan to put food on the table or keep the roof over your head, withdrawing money from your retirement account with a 401(k) debit card is a bad idea, in general, because of the tax consequences and fees involved in the borrowing. The SEC wants you to know some facts and think twice before swiping your 401(k) debit card at the checkout counter:

You must pay fees and interest on amounts you borrow from your 401(k) plan.

You will likely pay interest and incur fees if you use a 401(k) debit card to borrow money from your retirement savings. While some of the interest you pay will go back into your 401(k) account, a certain amount (called the “margin”) will be paid to the vendor of the card. In addition, the sorts of additional fees that may apply include: (i) an annual fee; (ii) a set up fee; (iii) a cash advance fee; and (iv) fees for other services, such as express delivery.

If you do not pay the money back in the time period required by the plan, there may be significant penalties and tax consequences.

Under IRS rules, you typically must repay the amount you borrow in five years or less, and may not fail to make payments for three consecutive months. If you do not meet those conditions, you must pay taxes on your loan balance. In addition, if you are younger than 59 1/2 years old, you will have to pay a 10% penalty.

The amounts set aside to borrow may earn a lower rate of return than the rest of your 401(k) assets.

The money you decide to borrow is set aside in a money market fund until you withdraw it. Money market funds may earn a lower rate of return than other investment options through a 401(k) account, such as investments in mutual funds or stocks.

Unlike your 401(k) contributions, you must make repayments on your own, and not automatically through a payroll deduction.

Typically, 401(k) contributions are deducted directly from your payroll – once you authorize the deductions, the money goes straight to your 401(k) automatically. Repayments of 401(k) debit card loans, however, are not deducted directly from your payroll – you must pay the balance yourself.

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Everybody agrees in general that a 401(k) loan or a 401(k) debit card is a bad, bad idea. For those of us who don’t have a guaranteed pension plan and can’t rely on social security, 401(K), as well as other individual retirement savings accounts, is one major tool to save for retirement when our pre-retirement incomes stop.

Since the money in the 401(k) account is for retirement, not for daily expenses, the government imposes an extra 10% penalty to discourage early withdrawals from the account. However, as the credit crunch goes on and home value keeps falling, more and more people start to have a hard time paying their bills or face losing their homes to foreclosure. At the same time, the cost of living is going nowhere but up: food, gas, health care, education, etc., things are getting expensive. Then there comes the creative idea of using a 401(k) debit card to borrow money from retirement accounts such as 401(k) to stay afloat, just like withdrawing cash from your private ATM machine.

I recently read quite a few articles on how a growing number of people are taking money out of their 401(k) accounts to save their homes. For example, in this USA Today story, Tamara Campbell, who lives in a Denver suburb

raided her 401(k) after her husband was laid off from his job as an occupational technician, and they fell behind on their mortgage for several months. “If I hadn’t done that, we would have been foreclosed on last year.”

Late last month, The Wall Street Journal reported that a survey among 2000 full-time workers conducted by Transamerica in 2007 found “49% of those who borrowed from their retirement savings said they took the loan to pay off debt, up from 27% in 2006.” And there are strong correlation between foreclosure rates and 401(k) loan or hardship withdrawal rates in regions of country where home prices are hit hard.

And for those who took money from their 401(k) accounts, not only they have to pay penalties and interests, but also could face shortfalls when they retire. Take a look at this example from The Wall Street Journal:

A participant with a $20,000 account balance who contributes $100 a month and earns an annual return of 10% would have $624,681 after 30 years. But if that participant borrows $10,000 from his plan and repays the loan at 7% interest over five years, halting contributions while he repays the loan but making $100 monthly contributions for the next 25 years, he would have only $523,502 at the end of the 30-year period.

Despite all the serious consequences of withdrawing from 401(k) accounts, if you are in a situation that you could lose your home if you can’t keep up with your mortgage payments, but have, say, $100K in your 401(k) account, would you withdraw from your 401(k) to save the roof under which you and your family live?

I would, as a last resort.

If that’s what you decide to do, then take this advice from The Wall Street Journal article:

If participants decide they must take out a 401(k) loan, they should aim to pay it off as quickly as possible and continue making new plan contributions while paying off the loan, taking full advantage of any employer-matching contributions.

Just like paying any debt requires responsibility and discipline, the same applies to 401(k) loans but with increased urgency.

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