It’s nice to see another tax-savings option available-one that provides tax-free withdrawals after you retire. This one became available on January 1 and combines parts of two popular plans, a 401(k) and a Roth IRA. Called the Roth 401(k), it allows employees to designate their contributions as Roth contributions and offers a significantly higher annual contribution than the Roth IRA. The Roth 401(k) allows for a maximum annual contribution of up to $20,000 in the 2006 tax year versus just $5,000 for the Roth IRA. Furthermore, unlike the Roth IRA, the Roth 401(k) does not impose income limits on investors who want to contribute.
The Roth 401(k) allows participants to contribute after-tax dollars to tax-deferred growth investments in exchange for tax-free withdrawals during retirement. In contrast, a traditional 401(k) is funded with pre-tax dollars and withdrawals are taxed as ordinary income. Thus, the Roth 401(k) combines key elements of the traditional 401(k) along with the tax benefits of the Roth IRA.
The combination of high contribution limits and tax-free income is particularly great news for proprietors of owner-only businesses. Since 2002 small businesses operated by the owner or the owner and spouse have had the option of establishing an owner-only traditional 401(k) plan. Now, with the availability of the Roth 401(k) plan, proprietors of owner-only businesses and also high-income earners who were previously excluded from establishing Roth IRAs can now make use of the benefits from a Roth 401(k) plan.
One reason high-income earners will find the Roth 401(k) most attractive is that, for the first time, they have access to a savings account that offers tax-free withdrawals in retirement. The only other savings account that currently offers that benefit, the Roth IRA, carries strict income stipulations. Roth IRA eligibility is off-limits for single filers with modified adjusted gross income exceeding $110,000 a year, and for joint filers with modified adjusted gross income exceeding $160,000 a year. However, the Roth 401(k) carries no such restrictions — anyone can invest in one so long as the employer provides this option. More than one-third of employers are expected to offer the new benefit (according to a survey conducted by ???)
Because the Roth 401(k) is funded with after-tax dollars, it may present a unique estate-planning benefit for wealthier people. With the traditional 401(k) or IRA, the government requires minimum distributions starting at age 70-1/2 to ensure people eventually pay some tax on the money. Currently, there is a minimum distribution requirement on the new Roth 401(k), but participants who reach 70-1/2 may be able to circumvent this by rolling their accounts into a Roth IRA, which does not have such requirements. People with a Roth IRA can delay taking distributions from the account, thus preserving what they can pass on to their heirs in a tax shelter. This cannot be done as well with a traditional IRA because of the minimum distribution requirements. Moreover, heirs who receive IRAs inherit the tax benefits of these accounts — although they are required to make some minimum distributions through their lifetimes.
The introduction of the new Roth 401(k) also offers the opportunity to increase overall savings. In effect, participants can prepay their retirement taxes today by switching from pre-tax to Roth savings at their current deferral rate. This is a more effective route than saving in the Roth IRA, which has contribution limits of $4,000 for those less than age 50 and $5,000 for those age 50 and above in 2006. If you have a Roth IRA, or plan to open one, you can still contribute the maximum allowable to that account in addition to your Roth 401(k) contributions.
If you have access to both a Roth and a traditional 401(k), you have three choices: You can continue to contribute solely to the traditional 401(k); you can divert your contributions to the Roth 401(k); or you can split your contributions between the two accounts. In any case, you are limited to the same contribution cap as people with just one 401(k): a maximum of $15,000 for 2006 or $20,000 for people age 50 and over by the end of the year.
The Roth 401(k) will allow many people to diversify tax risk and potentially enhance their after-tax savings in retirement. Pre-tax savings are more beneficial if a participant is in a lower tax bracket in retirement; Roth savings are more beneficial if a participant is in a higher bracket. In a world of uncertain future tax rates, participants should diversify. Just as they hold fixed-income assets to diversify the risks of stocks, so should participants hold Roth savings to diversify the risks associated with pre-tax savings.
It is important to note that the Roth 401(k) is only available for employee deferrals. Employer money (matching contributions, profit-sharing, etc.) cannot be part of the Roth 401(k). Also, contributions are irrevocable. Once the money goes into the account, it falls under all of the IRS rules and penalties for 401(k) accounts; you cannot change your mind and have it switched over to your regular 401(k). These Roth contributions will be subject to the same rules as Roth IRAs. That is, the money can be withdrawn tax- and penalty-free as long as you have held the account for at least five years and are at least age 59-1/2 or disabled.