Beginning in 2006, 401k participants at many companies can choose to make their retirement plan contributions to an account that works much like a Roth IRA. We have complete coverage of these accounts, including an explanation of how they make it possible to build more wealth for your retirement.
Roth 401k Overview
Tax-free retirement savings come to the 401k world.
As briefly as possible, a Roth 401k is a 401k account that functions pretty much like a Roth IRA. You get no deduction when the money goes in, but you'll have a huge advantage later because you're building an account where earnings will be permanently tax-free. For most people who are eligible, the Roth 401k will be preferable to a traditional 401k account.
How many employers are offering the Roth 401k?
Early survey responses indicated about a third of employers that have 401k plans planned on adding this feature as of January 1, 2006, but the actual number may have been smaller.
Roth 401k Compared with Traditional 401k
How one type of account differs from the other?
If your employer offers the Roth 401k, you have a choice to make: you can put all your retirement in a traditional 401k account, all in a Roth 401k account, or split your money between the two. Here's how they compare.
Different Tax Treatment
Your contributions to a traditional account 401k account reduce the amount of income you have to report, and that means a smaller tax bill in the year you made those contributions. You pay the piper later: all your distributions from that account are taxable, so you end up paying tax on your contribution plus all the investment earnings.
Your contributions to a Roth account don't reduce your tax in the year of the contributions, but all the earnings in that account will be tax-free for as long as the account exists. Furthermore, at termination of employment you can roll your Roth 401k account to a Roth IRA, so the account can continue to grow with tax-free earnings for as long as you choose to preserve it.
No Difference in Contribution Limits
You can contribute just as much to a Roth 401k account as to a traditional 401k account. Bear in mind that there is a single limit that applies to the overall total you contribute to both types of accounts. If your limit is $15,000, you can put that much in either type of account or split it between the two types, but your total contribution to both types can't be more than $15,000. No Difference in Investments.
You'll have the same investment opportunities for your Roth 401k account as for your traditional 401k account. Put this fact together with the fact that they have equal contribution limits and you'll see that you can accumulate just as much in a Roth 401k account as in a traditional 401k account.
No Difference in Matching Contributions
If your employer provides matching contributions for retirement savings, you'll get the same match for Roth 401k contributions as you would get for traditional 401k contributions. The only hitch is that the matching money has to go into a traditional 401k account.
Example: Your employer provides a 50% match on the first $4,000 of 401k savings. If you contribute $4,000 to a traditional account, your employer will add $2,000, so you'll see a total of $6,000 go into your traditional account. If you choose to contribute $4,000 to a Roth 401k account instead, your employer will put $2,000 into your traditional account. You still get total additions of $6,000 to your retirement savings.
Roth 401k Compared with Roth IRA
The Roth 401k offers some significant advantages over the Roth IRA.
Perhaps you're already familiar with the Roth IRA and want to know how the Roth 401k stacks up. Here's a rundown of the major differences.
No Income Limitation
The Roth IRA isn't available to taxpayers with income above certain levels. For unmarried filers, the contribution limit begins to phase out at $95,000 and is completely eliminated at $110,000. For joint filers the contribution limit is eliminated as joint income moves from $150,000 to $160,000. These limits shut the door on the world of tax-free retirement savings for many taxpayers.
The Roth 401k opens that door, because these limits don't apply to the Roth 401k. If you're eligible to participate in your employer's 401k program, and the employer offers the Roth 401k, you can make this choice without regard to your income level.
The dollar limits for 401k contributions are much higher than the limits for IRAs. Assuming you're otherwise eligible, in 2006 you can contribute up to $4,000 to an IRA (including a Roth IRA), or $5,000 if you're at least 50 years of age. The maximum contribution to a 401k (including Roth 401k) for 2006 is $15,000, or $20,000 if you're at least 50 years of age.
Various other limitations may prevent you from contributing the maximum amount to a 401k account, but most people who are eligible for these accounts will be able to set aside more money for retirement than they would if they relied solely on an IRA.
If your employer provides matching money for 401k contributions, you'll get that match regardless of whether you put your money in a traditional 401k account or a Roth 401k account. The matching money goes into your traditional 401k account even if you put your own contributions into a Roth 401k account — but even in the traditional account, this matching money is adding to the wealth you'll have in retirement. Different Accounts, Different Clocks.
In the world of Roth IRAs you have just one five-year clock for all your accounts (except for a special rule that applies to conversions). That isn't true for Roth 401k accounts. If you start an account with one employer in 2006 and start an account with a different employer in 2008, you have to deal with two different five-year periods. Assuming you're over 59½ or disabled, you can take qualified distributions from the first account beginning in 2011, but you'll have to wait until 2013 to take qualified distributions from the second account.
There's an exception if you roll the first account over to the second account. In this case, the entire account is treated as if it started in the earliest year of either of the two accounts.
Choice of Account
If you have both traditional and Roth accounts in the same 401k plan and you make a partial withdrawal, you should be able to choose which account the money is coming from. This choice may be useful for tax planning in general and also for avoiding nonqualifying distributions from the Roth 401k account, as described below.
Unless you're rolling your money to another Roth account (a Roth IRA or another employer's Roth 401k), you'll want your distributions to qualify for tax-free treatment. The rules here are similar to the Roth IRA rules. You need to have the account five years and in addition you have to be 59½ or disabled. (Distributions after your death can qualify also.)
Rollovers from Roth 401k Accounts
When you're eligible to take money from your Roth 401k account, you can roll it to a Roth IRA or to another employer's Roth 401k.
You may end up wanting to roll your Roth 401k account to a Roth IRA or to another employer's retirement plan. You should be aware of a few twists in these rules.
Rolling to a New Employer
When you change jobs, you may want to roll your account to your new employer's plan. You can't do this unless the new employer accepts Roth 401k accounts. In that situation, you have to either leave the money with the old employer or roll the account to a Roth IRA.
There's a special benefit if you can roll the account to a new employer: you get to count the "age" of the old account toward the five-year requirement for the new account. Without the rollover, you start all over with a new five-year requirement at the new employer.
The Treasury says you have to use a direct trustee-to-trustee rollover if you want to move your entire Roth 401k account to a new employer. This is to make sure the new employer will be able to keep track of the nontaxable amount in the new Roth 401k account. If you receive a distribution from a Roth 401k account, you're allowed to roll the taxable amount, but not the nontaxable amount, to a new employer's Roth 401k.
Contributing to a Roth 401k Account
Who's Eligible for the Roth 401k?
There are just two requirements. Beginning in 2006, you can contribute to a Roth 401k account if these two things are true:
- You are eligible to contribute to your company's 401k plan, and
- Your company has chosen to make Roth 401k accounts available.
No Income Limits
The tax law says you can't contribute to a Roth IRA if your income is too high, but those limits don't apply to the Roth 401k. The only limits that apply to the Roth 401k are the ones that apply to traditional 401k contributions. If you're allowed to contribute to a traditional 401k account, you're allowed to put some or all of that money into a Roth 401k account instead — if your company offers these accounts.
Asset Strategy Retirement Plan Consultants can help your organization decide if a Roth 401k makes sense and how best to inform and advise your employees on an ongoing basis.