Understanding the Roth 401(k)

Jill E. Thompson
Vice President of Financial/Consulting Services

As the name suggests, a Roth 401(k) combines features of the traditional 401(k) with those of the Roth IRA. It’s offered by employers like a regular 401(k) plan, but as with a Roth IRA, contributions are made with after-tax dollars. While you don’t get an upfront tax-deduction, the account grows tax-free, and withdrawals taken during retirement aren’t subject to income tax, provided you’re at least 59 1/2 and you’ve held the account for five years or more.

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. So far, 12% of all employers offer a Roth 401(k), according to Hewitt Associates, an employee benefits consulting firm, and 32% have indicated that they are likely do so this year.

The Roth 401(k) can offer advantages to high-income individuals who haven’t been able to contribute to a Roth IRA because of the income restrictions. (Roth IRA eligibility for 2008 phases out between $101,000 and $116,000 for single filers and $159,000 to $169,000 for those who are married and file jointly). There are no income stipulations for Roth 401(k)s.

In addition, Roth 401(k) accounts are subject to the contribution limits of regular 401(k)s — $15,500 for 2008, or $20,500 for those 50 or older by the end of the year — allowing individuals to put away thousands of dollars more in tax-free retirement income than they would through a Roth IRA. (In 2008, Roth IRA contributions are limited to $5,000 a year, or $6,000 for those 50 or older.)

The hitch: 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.

Employees who are offered this option face a choice. Making a sound decision hinges on your estimation of the taxes you think you’ll pay in retirement. 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). If you’re in your peak earning years, on the other hand, and you figure your tax bracket will be lower in retirement, you’ll benefit from continuing with traditional 401(k) contributions.

In reality, of course, things are much more complicated. For one, no one can predict with certainty what tax rates will be in the future, though the general consensus is that they’re likely to rise to help the government offset growing budget deficits and pay for Social Security and Medicare. That’s one reason why employees in the top tax brackets have indicated their preference for the Roth 401(k)—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.

Still have questions about the Roth 401(k)? We’ve gone ahead and answered the most important ones.

1. Who is eligible for a Roth 401(k)?
• Anyone whose employer offers it. This is where it gets tricky: Among the major concerns for employers are the costs associated with managing the plan, and educating their employees about this investment option. Employers are much more likely to offer 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.
2. What happens to the employer match?
• Employer matches are made with pretax dollars, and the match accumulates in a separate account that is taxed as ordinary income at withdrawal. # What are the early withdrawal rules? Early Roth 401(k) withdrawal rules are subject to the same requirements as the traditional 401(k).
3. What happens if I leave my current employer?
• The Roth 401(k) balance can be rolled over into a Roth IRA.
4. What happens if I plan to pass it on?
• With a traditional 401(k), the heir must pay taxes as he or she withdraws the money. However, an heir may be able to receive tax-free distributions of the money left through a Roth 401(k) if the account is at least five years old.
5. Is the Roth 401(k) option here to stay?
• Yes. At one time, the Roth 401(k) option was set to expire after 2010, but it was made permanent by 2006 legislation.

Notes: We recommend that you consult an independent legal or financial advisor for specific advice about your individual situation.