Roth 401(k)
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The Roth 401(k) is a type of retirement savings plan. It was authorized by the United States Congress under the Internal Revenue Service Code, section 402A [1], and represents a unique combination of the Roth IRA and a traditional 401(k) plan. As of January 1, 2006 U.S. employers have been free to establish Roth 401(k) accounts for their employees.
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[edit] Traditional 401(k) and Roth IRA plans
In a traditional 401(k) plan, introduced by Congress in 1978, employees contribute pre-tax earnings to their retirement plan, also called "elective deferrals". That is, an employee's elective deferral funds (currently up to $15,000. Will be $15,500 in 2007) are set aside by the employer in a special account and the funds are invested. Typically, employers also add funds to the account by contributing matching funds on a fractional formula basis (e.g., matching funds might be added at the rate of 50% of employees' elective deferrals). Both the elective deferrals, and the matching funds, are invested and grow on a tax deferred basis. Typically upon reaching the age of 59 and a half, the account owner begins to receive "qualified distributions" from the funds in the account, these distributions are then taxed at the ordinary income tax rates.
Under a traditional Roth plan, first enacted in 1996, individuals, whether employees or self-employed, voluntarily contribute post-tax funds to an individual retirement account (IRA). In contrast to the 401k plan, the Roth plan requires post-tax contributions, but allows for tax free growth and distribution, provided the contributions have been invested for at least 5 years. The amounts of income that can be invested in a Roth IRA are significantly more limited than those to a 401(k) are. For 2006, individuals are limited to contributing no more than $4,000 to a Roth IRA, if under age 50, and $5,000, if age 50 or older. Additionally, Roth IRA contributions are prohibited when taxpayers earn a Modified Adjusted Gross Income of more than $110,000, ($160,000 for married filing jointly).
[edit] The Roth 401(k) plan
The Roth 401(k) combines some of the best aspects of both the 401(k) and the Roth IRA. Under the Roth 401(k), employees can decide to contribute funds on a post-tax elective deferral basis, in addition to, or instead of, pre-tax elective deferrals under their traditional 401(k) plans. An employee's combined elective deferrals-- whether to a traditional 401(k), a Roth 401(k), or to both-- cannot exceed $15,000 for tax year 2006 if a participant is under 50; if they are over 50, they may contribute an additional $5,000. Employer's matching funds are not included in the $15,000 elective deferral cap.
In general, the difference between a Roth 401(k) and a traditional 401(k) is that the Roth version is funded with after-tax dollars while the traditional 401(k) is funded with pre-tax dollars. Typically, the earnings on Roth contributions will be tax free as long as the distribution is made at least 5 years after the first Roth contribution.
A Roth 401(k) plan will probably be most advantageous to those who might otherwise choose a Roth IRA, for example, younger workers who are currently taxed in a lower tax bracket, but expect to be taxed in a higher bracket upon reaching retirement age. The Roth 401(k) offers the advantage of tax free distribution, but is not constrained by income limitations. For example, normal Roth IRA contributions are limited to $4,000; whereas, up to $15,000 could be contributed to a Roth 401(k) account, provided no other elective deferrals were taken for the tax year (no traditional 401(k) deferrals taken).
[edit] Additional considerations
- Roth 401(k) contributions are irrevocable, such that once money is invested into a Roth 401(k) account; it can not be moved to a regular 401(k) account.
- Employees are able to roll their Roth 401(k) contributions over to a Roth IRA account upon termination of employment.
- It is the employer’s decision as to whether the company will provide access to the Roth 401(k) in addition to the traditional 401(k). Many employers may feel that the added administrative burden outweighs the benefits of the Roth 401(k)
- The Roth 401(k) plan will now be available after December 31, 2010 since legislative action was taken to extend the program.
