A Publication of WTVP

It’s called a Roth 401(k), and as its name suggests, it combines features of the traditional 401(k) with those of the Roth IRA. The Roth 401(k) concept was introduced with the Economic Growth and Tax Relief Reconciliation Act of 2001, which stipulated that employers could begin offering these plans on Jan. 1, 2006.

Employers may offer the Roth 401(k) by adding it to an existing profit sharing or 401(k) plan, but as with a Roth IRA, contributions will be made with after-tax dollars. While there is no upfront tax-deduction, the benefit is the account will grow tax-free and withdrawals taken during retirement will not be subject to income tax, as long as you are older than age 59½ and the account has been held for five years or more.

The Roth 401(k) could be a boon for high-income individuals who haven’t been able to contribute to a Roth IRA because of income restrictions (2007 Roth IRA eligibility phases out between $99,000 and $114,000 for single filers and $156,000 to $166,000 for those who are married and file jointly). There are no income stipulations for Roth 401(k)s.

In addition, Roth 401(k) accounts will be subject to the same contribution limits of regular 401(k), $15,500 for 2007 or $20,500 for those who are age 50 or older by the end of the year, allowing individuals to sock away thousands of dollars more in tax-free retirement savings than they would through a Roth IRA. (Now, Roth IRA contributions are limited to $4,000 a year or $5,000 for those who are age 50 or older.)

The hitch: Those limits apply to contributions to both types of 401(k) plans combined, so you can’t save $15,500 in a regular 401(k) and another $15,500 in a Roth 401(k).

Workers who are offered this option may face a difficult choice: contribute to a Roth 401(k) and suffer a cut in take-home pay (since contributions are made with after-tax dollars), or stick with a traditional 401(k) and hope that during retirement their tax rate will be lower than it is now. Alternatively, they could hedge their bets by contributing to both accounts.

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). This is likely to be the case with young people who are just starting their careers and expect their income to increase in the future.

On the other hand, if you are in your peak earning years and expect your tax bracket to be lower in retirement, you will benefit from continuing to make contributions to a traditional 401(k). In reality, of course, things are much more complicated. One reason people in top tax brackets have indicated a preference for the Roth 401(k) is no one can predict what tax rates will be in the future. Although the general consensus is that they are likely to rise to help the government offset growing budget deficits and pay for Social Security and Medicare.

Who is eligible for a Roth 401(k)?
Any employee whose employer offers the new plan is eligible to participate. While any employer can add a Roth 401(k) option to its plan, it is not required. Employers’ concerns include the costs associated with managing the plan and educating their workforce about this new investment option.

What happens to the employer match or profit sharing contributions?
Employer contributions will continue to be made with pre-tax dollars. The match will accumulate in a separate account that will be taxed as ordinary income at withdrawal.

What are the distribution rules?
The same restrictions as a traditional 401(k) apply. For the distribution to be tax-free, distribution must be made on or after attainment of age 59-1/2, death or disability, and must be made at least five years after establishment of the Roth 401(k) account.

What happens if an employee leaves the job?
The Roth 401(k) balance can be rolled over into a Roth IRA.

Is it here to stay?
Yes. The Roth 401(k) was a provision of the Economic Growth and Tax Relief Reconciliation Act of 2001 that was set to expire in 2010. With the signing of the Pension Protection Act of 2006, President Bush made these provisions permanent. IBI