Starting next year, employers will be able to offer a Roth 401(k) option as part of their benefits package to employees. The Roth 401(k) combines elements of the traditional 401(k) with those of the Roth IRA.
The ability to make contributions to a Roth 401(k) was added by the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), and will be effective for plan years beginning on or after January 1, 2006. If a plan permits, employees may designate all or a portion of their elective salary reductions to be treated as Roth contributions. However, the employer’s “matching” contribution will continue to go into the traditional 401(k).
Unlike traditional 401(k) plans, Roth 401(k) contributions are made with after-tax dollars. While you lose the tax deferral that you receive with a traditional 401(k), the earnings on the Roth 401(k) contributions are tax exempt. As a result, your weekly “take-home” pay will be less with a Roth 401(k), but your tax bill in retirement will be much smaller as you take tax-free distributions (must be made after age 59½ and 5 years after enrollment in the Plan). Distributions from a traditional 401(k) are taxed as ordinary income.
The Roth 401(k) will have the same contribution limits as the traditional 401(k): $15,000 a year for those under 50, and $20,000 for those over 50. And unlike the Roth IRA, the ability to make Roth 401(k) contributions will not be subject to gross income limitations (currently $110,000 for a taxpayer filing single and $160,000 for a taxpayer filing joint). As a result, higher income earners who did not have the option to participate in and benefit from a Roth retirement savings vehicle now do. Those individuals who are under the Roth IRA gross income limitations and contribute to a Roth 401(k) will still be able to make Roth IRA contributions as well (limited to $4,000 with a $1,000 catch-up in 2006), increasing the maximum amount of total Roth contributions to $19,000 (under 50) and $25,000 (over 50) for certain individuals.
If your employer does decide to offer the Roth 401(k), how do you decide if the Roth 401(k) is right for you? As a general rule, the Roth is a good savings vehicle if you expect to be in the same or higher tax bracket in retirement than you are now. This is likely to be the case for individuals beginning their careers who are currently in the lower tax brackets and expect their incomes to increase in the future.
For example, younger workers who are starting families and buying their first homes, but have not reached their peak earning years, may have large tax deductions which will typically push them into lower tax brackets. In this case, a Roth 401(k) may make sense for a few reasons. First, the tax deferral benefit of a traditional 401(k) is reduced the lower the tax bracket that an individual falls into. Second, the time horizon that younger workers typically have before retirement allows their original Roth 401(k) contributions to grow tax-free longer.
However, whether the Roth 401(k) makes sense for certain people is dependent upon what the national tax picture might look like in the future as well. Many experts predict that taxes are going to increase in the future to pay off the nation’s financial debt. If tax rates do rise, investing in a Roth 401(k) and paying taxes upfront is a good deal. But one must consider the chance that the government will dump the current tax system and replace it with a flat tax or sales tax. If this were to happen, workers who invested in the traditional 401(k) would be ahead.
Another factor to consider in deciding between the Roth 401(k) and the traditional 401(k) is the requirement of minimum distributions. The Roth 401(k) does require minimum distributions, however, individuals would be able to avoid this by rolling their Roth 401(k) accounts into a Roth IRA which does not have such requirements. With the traditional 401(k) and IRA, minimum distributions are required starting at age 70½ to ensure people eventually pay tax on their contributions. By rolling a Roth 401(k) into a Roth IRA, individuals can delay taking distributions and allow the Roth to continue to grow tax-free. However, it should be noted that this loophole may be closed in the near future.
Having a new retirement-savings option to choose from is exciting, but whether or not to contribute to the new Roth 401(k) or a traditional 401(k) is dependent upon your individual circumstance. If after all of your research you are still unsure in which to participate, you may consider contributing to both and hedge against an increase or decrease in the tax rates during your retirement years. But take note that the window to contribute to a Roth 401(k) is set to close in 2010 unless Congress takes steps to extend this benefit.
