Introducing the Roth 401(k)

Introducing the Roth 401(k)By Wilson Ziegler

The new Roth 401(k) combines features of the traditional 401(k) with those of the Roth IRA. Employers will offer it in the same manner as a regular 401(k), but as with a Roth IRA, contributions will be made with after-tax dollars. The Roth 401(k) concept was introduced with the Economic Growth and Tax Relief Reconciliation Act of 2001, which stipulated that employers could start offering these plans on Jan. 1, 2006.

The Roth 401(k) could be a boon for high-income individuals who haven't been able to contribute to a Roth IRA because of the income restrictions. (Eligibility for 2007 phases out between $99,000 and $114,000 for single filers and $156,000 to $166,000 for those who are married and file jointly). There are no income stipulations for Roth 401(k)s.

In addition, Roth 401(k) accounts will be subject to the contribution limits of regular 401(k)s — $15,500 for 2007, or $20,500 for those 50 or older by the end of the year — allowing individuals to stock away thousands of dollars more in tax-free retirement income than they would through a Roth IRA. (In 2007, Roth IRA contributions are limited to $4,000 a year, or $5,000 for those 50 or older.)

Those limits apply to contributions to both types of 401(k) plans, so you can't save $15,500 in a regular 401(k) and another $15,500 in a Roth 401(k). "There's no new opportunity to save here, but there's an opportunity to save with a different kind of tax treatment," says David Wray, president of the Profit Sharing/401(k) Council of America (PSCA).

While you won't get an upfront tax-deduction, the account will grow tax-free, and withdrawals taken during retirement will not be subject to income tax, provided you're at least 59 1/2 and you've held the account for five years or more. Workers who are offered this new option next year face a difficult choice: Contribute to a Roth 401(k) and suffer a cut in take-home pay (since contributions are made with after-tax dollars), or stick with a traditional 401(k) and hope that in retirement, their tax rate will be lower than it is now. Alternatively, they could hedge their bets by contributing to both accounts.

Making a sound decision will be determined on your estimation of the taxes you think you'll pay in retirement, says Michael Kitces, director of financial planning with the Pinnacle Advisory Group in Columbia, Md. If you expect your tax rate to be the same or higher in retirement than it is now, you might be better off with a Roth 401(k). This is likely to be the case with young people who are just starting their careers and expect their income to increase in the future. "For those who are in the 15% or 25% tax bracket, it may not be a bad idea to pay those taxes now and never have to worry about what tax brackets might become in the future," says Kitces. On the other hand, if you're in your peak earning years and you figure your tax bracket will be lower in retirement, you'll benefit from continuing with traditional 401(k) contributions.

In reality, things are quite that simple. No one can predict what tax rates will be in the future, but they're expected to rise to help the government offset growing budget deficits and pay for Social Security and Medicare. That's one reason people in the top tax brackets have indicated their preference for the Roth 401(k), says Wray. "They are ready to pay the regular tax now, whatever it is, because the certainty that they won't have to pay taxes in the future offsets the value of the tax deferral."

Here are some important questions about the Roth 401(k):

How do I know if I'm eligible for the Roth 401(k)?

If your employer offers it, you're eligible. Any employer can add a Roth 401(k) option to its plan, but they aren't required to do so. Among the major concerns for employers are the costs associated with managing the plan, and educating their workforce about this new investment option. According to the PSCA's Wray, companies will be much more likely to start offering a Roth 401(k) if their employees indicate that they intend to participate. So if you want a Roth 401(k) option to be added to your plan, make sure to let your employer know.

What happens to the employer match?

Employer matches will still be made with pretax dollars and the match will accumulate in a separate account that will be taxed as ordinary income at withdrawal.

What are the early withdrawal rules?

It looks as thought early Roth 401(k) withdrawal rules will be subject to the same requirements as traditional 401(k)s, according to Kitces. However, those regulations aren't set in stone. If your company rolls out a Roth 401(k) next year, be sure to ask your plan manager.

What happens if I leave my job?

The Roth 401(k) balance can be rolled over into a Roth IRA.

Is the Roth 401(k) option here to stay?

Yes. At one time, the Roth 401(k) option was supposed to expire after 2010, but it was made permanent by legislation in 2006.