Get Ready for the Roth 401(k)

by Lori Mayer

Effective January 1, 2006, 401(k) plan sponsors may allow participants to designate some or all of their traditional 401(k) contributions as Roth 401(k) contributions. This is increasingly generating interest and questions. We’re ready to help by providing insightful information about the Roth 401(k) contribution in this article.

What is a Roth 401(k) contribution and how is it different from the traditional 401(k) contribution?

The traditional 401(k) contribution is made with pre-tax dollars. The account’s gains are also tax-deferred. However, you owe taxes on all money that is withdrawn. A Roth 401(k) contribution will be made with after-tax dollars and the money grows tax-free. Therefore, no tax is paid when the funds are taken out.

In a nutshell, with the traditional 401(k) option, money withdrawn from the plan is taxed. With the Roth option, the contributions are taxed.

What are some of the advantages to offering the Roth 401(k) to plan participants?

  • Younger Employees – Participants who are currently in a lower tax bracket and expect their income to increase may want to consider paying taxes now rather than later.
  • Highly Compensated Employees - Single employees that made over $110,000 and married couples that had a combined income of over $160,000 are ineligible to contribute to a Roth IRA. However, they may contribute Roth 401(k) contributions because there are no income limits on the 401(k) Plan.
  • Plan limits – For 2006, the Roth IRA limit is $4,000 ($5,000 if age 50 or over). The Roth 401(k) limit is the same as the traditional 401(k) limit which is nearly four times as much. For 2006, the 401(k) limit is $15,000 ($20,000 if age 50 or over).
  • Flexibility in tax planning – Participants will have the flexibility to split their contributions between a traditional 401(k) and a Roth 401(k). During years when the income tax rate is high, retired participants can withdraw from their Roth 401(k). When the tax rates are low, participants can withdraw from their traditional 401(k) account.
  • Avoid Required Minimum Distributions – Since Roth IRA’s are not subject to Required Minimum Distributions at age 70 ½, rolling the Roth 401(k) to a Roth IRA is a way of avoiding the minimum distribution requirement.

What are the disadvantages?

  • Separate Accounting – A little more work is involved on the record keeping side to make sure Roth 401(k) contributions are not commingled with any pre-tax money in a participant’s account.
  • Payroll – The payroll system must be able to correctly tax the Roth 401(k) contributions, but not the traditional 401(k) contributions.
  • 5 Year Wait – If a participant with a Roth 401(k) account takes a distribution during the initial 5 year period, the participant’s earnings will be taxed.

If you now offer a 401(k) for yourself and your employees, adopting the Roth 401(k) option may be a tremendous chance for you and your employees to add to retirement savings.


Traditional 401(k)Roth 401(k)
FundingFunded with pre-tax dollarsFunded by after-tax dollars
Matching ContributionsAllowedEmployer matching of Roth 401(k) contributions is allowed but not as an after tax contribution. The employer match is treated the same as it is for pre-tax contributions
Contribution Limits$15,000 ($20,000 if age 50 or older)$15,000 ($20,000 if age 50 or older); if participant makes a combination of Roth 401(k) and pre-tax elective deferrals, total cannot exceed ($15,000/$20,000)
Investment EarningsTax-deferred earningsTax-free earnings
TaxesPay taxes laterPay taxes now
Access to MoneyCan get access to money when leaving a job, disabled, die or (if plan provides) reach age 59 ½Subject ot the same restrictions as traditional 401(k)
Tax-Free DistributionNot Applicable2 conditions must be met: 1) Distribution must be a “qualified distribution”-attainment of 59 ½, death or disabled AND 2) Special 5-year-rule – contributions must remain in the plan for 5 years of the first Roth 401(k) contribution to receive the tax-free advantage
RolloversCan be rolled over into a traditional IRACan be rolled over into a Roth IRA

 

Traditional 401(k)

Roth 401(k)

Funding

Funded with pre-tax dollars

Funded by after-tax dollars

Matching Contributions

Allowed

Employer matching of Roth 401(k) contributions is allowed but not as an after tax contribution.  The employer match is treated the same as it is for pre-tax contributions

Contribution Limits

$15,000 ($20,000 if age 50 or older)

$15,000 ($20,000 if age 50 or older); if participant makes a combination of Roth 401(k) and pre-tax elective deferrals, total cannot exceed ($15,000/$20,000)

Investment Earnings

Tax-deferred earnings

Tax-free earnings

Taxes

Pay taxes later

Pay taxes now

Access to Money

Can get access to money when leaving a job, disabled, die or (if plan provides) reach age 59 ½

Subject ot the same restrictions as traditional 401(k)

Tax-Free Distribution

Not Applicable

2 conditions must be met:

1) Distribution must be a “qualified distribution”-attainment of 59 ½, death or disabled AND

2) Special 5-year-rule – contributions must remain in the plan for 5 years of the first Roth 401(k) contribution to receive the tax-free advantage

Rollovers

Can be rolled over into a traditional IRA

Can be rolled over into a Roth IRA