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A New Type of Savings Plan: The Roth 401(k)

What is the Roth 401(k)?

In 2001 Congress passed the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) which in part created a new form of retirement savings plan called a Roth 401(k).  The Roth 401(k) is a new type of savings plan combining a traditional 401(k) with a Roth IRA.  Employers were given the option of implementing the new Roth 401(k) on January 1, 2006.

How is the Roth 401(k) different from the traditional 401(k) and Roth IRA?

• In a traditional 401(k) the participant may put money into the plan and the amount contributed is deducted from the participant’s taxable income for the year.  However, a Roth 401(k) will impose income tax on the amount contributed even though it will be in a retirement account.

• In a traditional 401(k) the money in the plan builds up tax free, but when the participant makes withdrawals, the amount withdrawn is treated as taxable income.  In the Roth 401(k) the money also builds up tax free, and since the money was taxed going in it is not taxed upon withdrawal.  Withdrawals are not taxed so long as they are taken after the participant is age 59 ½ and 5 years have elapsed since the date of the first contribution.

• A Roth IRA has a 2007 maximum annual contribution limit of $4,000.  The new Roth 401(k) has a maximum contribution limit of $15,500 for the year 2007.

• A Roth IRA has an income restriction preventing individuals with annual income of more than $100,000 from contributing.  The new Roth 401(k) has no income restriction.

• A traditional Roth IRA does not require mandatory distributions upon reaching a certain age.  The Roth 401(k) will require that participants take minimum distributions after reaching age 70 ½.  This mandatory minimum distribution can be avoided by rolling over the Roth 401(k) into a Roth IRA if the participant leaves the employer.

What should you know before changing to the Roth 401(k) from your traditional 401(k)?

• Because your contribution to the Roth 401(k) is not tax deductible, you may find yourself in a higher tax bracket that you would be if you continued contributing to a traditional 401(k).

• Remember that you will not pay taxes on the money you withdraw from your Roth 401(k) since you paid tax in the year you made the contribution unlike the 401(k) which taxes withdrawals.  The plan that is best for you depends on whether you think you will be in a lower or higher tax bracket in the years you plan on making withdrawals from your Roth 401(k).