Sound Mind Investing : Introducing the Roth 401(k)

	Subscription Information \| About SMI
	Search:

Home : 2006 Back Issues : Article

Introducing the Roth 401(k)

By Mark Dodge, MBA, AAMS, CWA

Many different company retirement plans exist to meet the needs of today's workers. The 401(k), 403(b) and SEP-IRA are a few examples. Yet, despite the many types of retirement plans and their investment options, each unfortunately has the same shortcoming—you can not take a distribution from a retirement plan without paying income taxes.

Thanks to Congress, or more specifically the men and women of Congress who helped pass the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), this is no longer the case. This tax relief act ushered in numerous changes to the estate planning process, and now is presenting investors with a new investment vehicle that has distinctive benefits unlike any other retirement plan to date. After five years of waiting, companies can finally begin offering the new Roth 401(k) option to employees. As you might suspect by its name, a Roth 401(k) takes certain aspects of a Roth IRA and blends them into the 401(k) concept.

The most noteworthy feature that a Roth 401(k) has taken from a Roth IRA is the tax treatment of the investment. With a Roth IRA, the investor contributes dollars that have already been taxed (often referred to as "after-tax" contributions). The money invested then grows tax-deferred. The unique feature of a Roth IRA is that the money contributed, as well as any earnings accumulated, is eventually distributed tax-free. So by investing in a Roth IRA, you pay Uncle Sam his portion now and enjoy your golden retirement years tax-free. If that sounds like a bargain, it is! This is a wonderful feature, especially for young investors who have many years to accumulate tax-free earnings before retirement.

The Roth IRA has some shortcomings, however. One key limitation is the restriction on who may contribute. If you make too much money (in the eyes of government) you are not allowed to contribute to a Roth IRA. Currently, single filers earning more than $110,000 annually, or married filers earning more than $160,000, are not eligible to make contributions into a Roth IRA. A second key limitation is the amount you are allowed to contribute. For 2006, the contribution limit for a Roth IRA is $4,000 with an additional $1,000 allowable if you are at least 50 years of age. This is substantially less than the amount most employees are allowed to contribute to their 401(k) plans.

Thankfully, both of these restrictions are eliminated with a Roth 401(k). Regardless of your income, you can take full advantage and contribute the maximum amount allowed. That amount for 2006 is $15,000 with an additional $5,000 allowed if you are at least age 50. Higher-income earners who have been shut out of Roth IRAs will finally have the chance to invest on similar terms.

As mentioned, there are also features of a Roth 401(k) that were taken from "regular" 401(k) plans. The most notable is the employer matching concept (one of the few times it pays to be the employee and not the employer). For example, employers commonly will match 50 cents for every dollar you contribute, up to 6% of your salary. Under that scenario, if you earn $3,000 a month and contribute 6% ($180), your employer will "match" your contributions with an additional $90.

Similarly in a Roth 401(k), an employer match is possible (assuming your employer chooses to provide one). In the Roth 401(k) though, matching comes with a twist. The employer match will continue to be made with pre-tax dollars, grow tax-deferred, and be taxed upon distribution. This will take place in a separate account within the Roth 401(k). This account is to keep separate the money that will eventually be taxed upon distribution. In other words, employee contributions will be given "Roth" tax treatment: taxed when money is put into the retirement plan and tax-free when money is taken out. But any matching contributions by the employer will be treated like "regular" 401(k) money: not taxed going into the plan, but taxed when it is eventually taken out.

Note that both the Roth IRA and Roth 401(k) require you to be 59½ or older and invested for 5 years or more to avoid penalties and taxes on distributions. Penalties and taxes are waived if you die or become disabled.

As with a regular 401(k), you are required to begin taking distributions from a Roth 401(k) starting at age 70½. Because a Roth IRA does not have this age requirement on its distributions, you can avoid this mandatory feature if you wish by later converting your Roth 401(k) into a Roth IRA. (Because your contributions and any employer-matching will require different tax treatment, this may involve a two-step process.) When you leave a company where you've had a Roth 401(k) account, you might consider this as part of your longer term strategy.

As with most of the tax relief provided in EGTRRA, the Roth 401(k) expires, or "sunsets", after December 31, 2010. President Bush has indicated that he would like to make these tax relief provisions permanent, or at least extend them. However, if these provisions are not extended beyond 2010, no new contributions will be allowed into Roth 401(k)s beyond that date. If that happens, current Roth 401(k) holders will likely be able to keep their accounts or roll them over to Roth IRAs.

If you are hesitant to jump with both feet into these unfamiliar waters, you could consider contributing some money pre-tax to your regular 401(k), while also making some after-tax contributions to a Roth 401(k). This might provide some additional comfort while still offering the unique tax benefits of the Roth 401(k) for at least a portion of your investment. You can always change the allocation of new money between the two as you become more comfortable with your investment options.

If you're interested in participating in a Roth 401(k), let your employer know. Any employer can add the option starting January 1, 2006. However, even though the Roth 401(k) option will be allowed, it doesn't mean that your company will be eager to add it immediately. Many companies are taking a wait and see approach to the Roth 401(k). These companies are watching to see how other companies address administrative issues and educate their workforce about this new investment.

So, if you are a young investor that has several years (or decades) until you retire, a Roth 401(k) is likely a good vehicle to help you reach retirement goals. By having time on your side, your investments will have the opportunity to grow to a substantial amount. By the time retirement arrives, not only will your investments have grown considerably, but a significant portion will be tax-free! (Amounts related to an employer's match, remember, will be taxable.) If you are an investor who is closer to retirement, a Roth 401(k) may also be a nice addition to your retirement plan. You may want the tax-free income in retirement or perhaps the option of being able to avoid the minimum distributions. On the other hand, if you are relatively close to retirement age and believe your tax rate may decrease when you retire, you'll likely want to remain in a regular 401(k), so as to pay taxes later at those lower rates. In many respects, this decision mirrors one investors have been making for years now: the Roth vs. Traditional IRA decision. Chapter 23 in the Sound Mind Investing Handbook contains a complete discussion of those pros and cons and is worthwhile reading for those considering the new Roth 401(k).

Mark Dodge an Accredited Asset Management Specialist and a Chartered Wealth Advisor. Mark has worked in both the securities and accounting industries and taught finance courses at the university level.