IRA Alternative: Roth Your 401(k)

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By now, most investors know something about Roth IRAs, and about the option of converting a traditional IRA into a Roth. But there may be another option: investing in a Roth 401(k) at work.

The 401(k) version of the Roth doesn’t get much attention, but can be especially good for people who would like to hedge their bets with two types of retirement accounts.

Roth 401(k)s work like Roth IRAs. You get no tax deduction on contributions, while withdrawals, including investment gains, are tax-free. But there are two key differences.

First, there is no income limit for opening a Roth 401(k). Anyone can have one if your employer offers it. To open a Roth IRA and make the maximum contribution, your modified adjusted gross income must be below $105,000 if you are single, $166,000 if you are married and file a joint return. (There is no income limit for converting a traditional IRA into a Roth.)

Second, you can put much more into a Roth 401(k) — $16,500 a year, or $22,000 if you are 55 or older. For a Roth IRA, the figures are $5,000 and $6,000.

You don’t hear much about Roth 401(k)s because most people prefer traditional 401(k)s. Those offer an income-tax deduction on contributions, while withdrawals are taxed as income. Most people assume their tax bracket will be lower in retirement than in their working years, so the traditional 401(k)’s upfront deduction is more valuable than the Roth 401(k)s tax exemption on withdrawals.

But you can only guess what your income will be in retirement, especially if that’s many years away. And no one knows what tax brackets will be in 10, 20 or 30 years. So one option is to divide your contributions between a traditional 401(k) and the Roth version. That way, you can hedge your bets. After you retire, you can take money out of the Roth in years when your tax bracket is high, then use the traditional 401(k) when it is low.

The Roth 401(k) can also be an alternative to converting a traditional IRA into a Roth IRA, according to Sharebuilder Advisors, a subsidiary of ING Bank (Stock Quote: ING) that provides 401(k) plans to small businesses.

In Sharebuilder’s example, an investor is considering whether to convert $30,000 in a traditional IRA into a Roth. That would trigger a $7,500 income tax, assuming a 25% tax bracket. The investor could pay the whole tax in 2010, or pay $3,750 in 2011 and $3,750 in 2012.

As an alternative, the investor could simply steer new paycheck deductions into a Roth 401(k) instead of the traditional 401(k). By doing this with $10,000 a year, the investor could amass $30,000 in the Roth 401(k), duplicating what could be done with a conversion. Since there would be no tax deduction on these contributions, the switch from the traditional to Roth 401(k) would increase the investor’s income tax by $2,500 for each of the three years.

But it might be easier and more convenient to spread this $7,500 tax over three years than to pay it in one or two. Of course, the investor could go the conversion route and reduce the annual tax bite by spreading the conversion over two, three or more years. But that would take some discipline, while simply redirecting 401(k) contributions would make the process automatic.

It’s another option — worth considering if you like the idea of having both traditional and Roth accounts in retirement.

Many employers who offer traditional 401(k)s do not offer the Roth variety. But Sharebuilder says it is very inexpensive for an employer to add the Roth option, so many firms will do so if employees ask.

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