Roth 401k Plans

Starting on January 1, 2006 the Roth 401k was born. Since that time, many employees have found themselves faced with the question - Do you want to contribute to a Roth 401k? We're going to help answer that question by discussing the Roth 401k rules, contribution limits, withdrawals / distributions, and even how to make a 401k Roth rollover.

Background of the Roth 401k

The Roth 401k provision was part of the Economic Growth and Tax Relief Reconciliation Act that became effective in 2006. As its name implies, a Roth 401k combines the contribution features of 401k plans with the tax-free growth advantage of Roth IRAs. The appeal of the Roth 401k seems too good to be true, and a recent survey conducted by benefits giant Hewitt Associates estimates that nearly 35% of companies are likely to offer this type of plan to its employees.

Roth 401k Basics

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The following is an example of how the basic Roth 401k plan will work. Keep in mind that each employer has some latitude in how they want to administer their plan. In fact, just because it's possible for a company to offer a Roth 40k plan to its employees does not mean that all employers will take advantage of this provision.

Employees offered a chance to participate in a Roth 401k will now have the option of setting money aside from their regular paycheck on an after-tax basis to a retirement account that will grow tax-free forever. That means you never have to pay taxes on the growth portion of the account and you don't have to pay federal income taxes at the time of withdrawal - just like a Roth IRA.

Benefits of a Roth 401k

Perhaps the most important question you'll struggle with is: "Should I fund a Roth 401k or stick with my old 401k plan?" For most of us, the question really comes down to income taxes and your income tax bracket.

By making a before-tax contribution to your 401k plan, you're reducing your current tax liability. With Roth 401k contributions, you're making after-tax contributions.

Before-tax contributions reduce your taxable income now, but you're going to pay income taxes on the contributions and earnings when they're distributed to you at retirement.
Roth 401k contributions don't reduce your taxable income right now, but these contributions, and earnings on them, are tax-free at retirement - as long as you're at least age 591/2 and your Roth 401k account is at least five years old.

So if you believe you're in a higher tax bracket today then you will be in retirement, sticking with a 401k plan might be your best move. If you think your tax bracket will stay the same or increase in your retirement years, then a Roth 401k is probably your best move.

Roth 401k Rules

The Roth 401k rules pretty much follow the pattern mentioned above - they're really just a combination of the Roth IRA rules and 401k rules. The information listed below should give you a more detailed explanation of what to expect if you're offered a chance to participate in this kind of retirement plan.

Roth and 401k Accounts

The new Roth 401k plan will be offered in addition to existing Roth IRAs and 401k plans - it does not replace these plans. That means if your employer does not offer you a Roth 401k, then you still have the option of funding a Roth IRA or your 401k. Any company that presently is eligible to offer its employees a 401k plan can offer a Roth 401k plan.

Roth 401k Contributions

The contribution rules for Roth 401ks are the same as those for existing 401k plans. Specifically, the maximum contribution you can make to a Roth plan is the same as today's 401k - including the catch up provisions of the 401k. That means in 2009, you can contribute up to $16,500 to your plan (plus employer matching - which can only go into a traditional 401k plan) and employees age 50 and over can contribution up to $22,000.

In 2010, Roth 401k contributions remained at $16,500. And for those age 50 years and older in 2010, the $5,500 catch-up contribution raises the total limit to $22,000.

You can also make a "standard" Roth IRA contribution that is in addition to the contribution limits just mentioned. With the tax advantages of this new plan, the Roth 401k will be hard to resist. That's because it also opens up the tax advantages of Roth IRAs to a much broader number of employees - many highly compensated individuals were not eligible to contribute to a Roth IRA.

Employer Contributions

If your Roth 401k plan includes employer matching, then you will have to pay federal income taxes on the employer match when withdrawn. Remember, your contributions will be on an after-tax basis, but you didn't have to pay income taxes on employer contributions when they went into your account, so you will have to pay when you take a distribution.

Roth 401k Withdrawals

Like its predecessors, the Roth 401k was established as a retirement plan. That means the IRS looks down on withdrawals that occur before age 59 1/2. Hardship or other types of withdrawals are subject to the same 401k rules and penalties that are currently on the books. The Roth 401k minimum distribution rules are also similar to 401k withdrawals - meaning you need to start to take distributions when you reach age 70 1/2.

Roth 401k Rollovers

The way the law is written, you can roll-over a Roth 401k into to a Roth IRA when your employment is terminated or at retirement. This seems to be a loophole which allows you to get around the minimum distribution requirement at age 70 1/2 - just simply rollover the Roth 401k into a Roth IRA (which has no minimum distribution requirement).

Final Words on Roth 401k Plans

Perhaps the most difficult choice for most employees involves the pre-tax contribution of a 401k versus an after-tax contribution of a Roth 401k. Remember, if you plan to maintain the same contribution levels on an after-tax basis, then it will mean less take home pay in your check.

Again, keep in mind that the contribution decision is sometimes based on what you think your tax bracket or tax rate will be in the future. If you expect your tax bracket will be higher or the same as it is now when you are retired, then you are probably better off with a Roth 401k. If you think you will be in a lower tax bracket in retirement, then the tax free withdrawal advantage of the Roth 401k plan is diminished.

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