The Good, the Bad … and the Odd of the ROTH 401(k)

The new ROTH 401(k) – which just became available in January – is all the “buzz” in the financial world. It is available as either a company-sponsored plan or for an individual businessperson.

While potential ROTH 401(k) custodians scramble to decipher and interpret the new law, other experts are still weighing in and vigorously debating the “pros” and “cons.” So let’s quickly take a look at the good, the potentially bad … and the odd. The Good

You can buy all sorts of non-stock investment products with it.

You can sock away far more tax-advantaged dollars than you could with an IRA.

You can borrow against it.

With a little smart strategizing, you can use it as a powerful estate planning vehicle.

It’s designed to allow you to pay taxes now while, in return, you get tax-free earnings and distributions for the rest of your life. The Potentially Bad

The ROTH IRA and the ROTH 401(k) are based on the idea that certain taxpayers may be better off trading today’s known tax dollars for tomorrow’s unknown tax dollars. In essence, you are gambling that your tax rate will be higher in the future.

But there is another school of thought that says “Take the tax savings now.” After all, proposals of a nationwide flat tax, if ever passed, would render all of the pre-paid tax dollars in a ROTH IRA and ROTH 401(k) rather meaningless. And the fact is, politicians don’t have a good track record when saying that Social Security and other retirement plans are “sacred” and will never be taxable. The Odd

Strangely, Congress wrote this new law with a provision that automatically terminates the law in 2010. Therefore, until and unless the ROTH 401(k) is extended, one must assume a taxpayer has only five years to implement and utilize the retirement program’s benefits.

However, during those five years, you may be able to sock away up to $98,000 per year. That would be up to $490,000 going into your retirement plan to grow tax-free. And you can use your funds to purchase land, homes, apartment units, leases, water rights, tax liens, discounted real estate notes, etc. Can you imagine having $490,000 compounding year after year … and with earnings and distributions that are tax free forever?

Well, maybe not forever … and this latent doubt is the major concern of many financial experts who have reviewed and written about the ROTH 401(k). The Middle Ground

One interesting approach is akin to Wall Street’s market philosophy: Buy both stocks and bonds as countermeasures to each other. That way, you are protected regardless of which way the market turns. You may not make a lot – but you won’t lose a lot (or so the theory goes).

In much the same vein, a taxpayer can have both a pre-tax-dollar retirement plan (a traditional IRA, SEP, or 401(k)) and an after-tax-dollar investment plan (a ROTH IRA or ROTH 401(k)). This would balance the risk and provide insurance that something will be available no matter how the political winds shift.

Who Could Really Benefit and How

Please note that the ROTH 401(k) has two distinct applications. One is for a company employee with possible matching employer contributions, and the other is for an individual businessperson – where the benefits can be huge.

Our focus will be the individual or business ROTH 401(k), because only 10 percent of employers are currently offering this new retirement product, and only 34 percent are seriously considering offering it.

Those employees who are offered the ROTH 401(k) will be allowed $15,000 – $20,000 in annual contributions, depending on their age.

For individuals, the ROTH 401(k) offers, among other things:

a. no income ceiling restrictions (vs. the current $110,000 single and $160,000 married ceiling restrictions with the ROTH IRA)

b. the opportunity for a couple with a business to put away up to $98,000 annually, if they file jointly and work as employees of their corporation

c. the ability (under the proper circumstances) to personally borrow up to $50,000 against your own ROTH 401(k)

d. the ability to buy life insurance in your insurance plan (which is not possible with a ROTH IRA)

e. the ability to buy “S” corporation stock, which can allow you to invest a portion of your retirement funds in a new business that you or a colleague are starting (not possible with a ROTH IRA)

f. the ability to buy real estate

g. under the right circumstances, the ability to buy real estate using leverage (That is, if non-recourse financing is employed, there will not be any taxes due to UBIT – Unrelated Business Income Tax at 35 percent – on any income derived from the investment. There will also be no tax on any gains realized from the leveraged appreciation when the real estate is sold.)

That’s a powerful package of benefits. And there are even more that I haven’t mentioned. Yet, to take advantage of the ROTH 401(k), you need to be informed.

After all, as the maxim goes, “With the benefits run the burdens.” And the new ROTH 401(k) is no exception. Again, right now, the law is set to expire in five years. Also, unlike its cousin, the ROTH IRA, distributions must be taken at age 70 and a half.

The fact that distributions need never be taken by a ROTH IRA holder during his/her lifetime is a major reason many Americans prefer it. It means they can pass a lucrative retirement plan onto their heirs tax-free (including, for example, a cash-pumping apartment house that is paid for and generating dependable monthly cash flow).

Of course, active minds have already theorized a way to avoid that mandatory ROTH 401(k) distribution. They have suggested the taxpayer could simply roll over his/her ROTH 401(k) into a regular ROTH IRA before age 70 and a half. This could be a very effective estate planning move if the taxpayer will never need the income or principal and wants to pass it on to heirs. Your Informed Choices

You really do have more choices than ever for your retirement planning.

If you are currently saving with a traditional 401(k), IRA, or ROTH IRA, you may be missing out on some investment options that make much more sense for your personal situation. If you own your own business, or are considering buying or starting one, you should look into these options. If you own a second home, investment property, or if you are thinking about purchasing a home for your retirement years, you absolutely don’t want to pass these chances by. Choosing the right plan can help you reach your retirement goals much earlier.

[Ed. Note: Tom Phelan is a nationally recognized speaker and authority on the topic of Self-Directed IRAs and Tax Advantaged Real Estate Investing.]