Roth 401(k): A New Work-Based Savings Option
Course Section
By the National Endowment for Financial Education
The newest offering in work-based retirement savings accounts is the Roth 401(k). It combines certain features of a Roth IRA and a regular 401(k) account. A Roth 403(b) plan is also now available for individuals working in the non-profit sector.
The legislation authorizing the Roth 401(k) is set to expire at the end of 2010. If Congress extends the Roth provisions, you should be able to roll your Roth 401(k) account into a Roth IRA. Or, you could hold it in an existing account although you won’t be able to make new contributions.
While both the regular and the Roth 401(k) plans enable workers to save for retirement, there are important differences.
Contributions and Withdrawals
Employees can contribute up to $15,000 of their salary to a regular and Roth 401(k) combined. To “catch-up” on saving, employees 50 and older can contribute another $5,000 yearly to either type of account.
Unlike the regular 401(k), a Roth 401(k) is funded with post-tax dollars. Participants pay the taxes out of current income, but the withdrawals will be tax-free. The tax-free provision of the Roth 401(k) applies only if the funds have been held for at least five years. Withdrawals cannot begin before 59½ but must begin by 70½.
Already have a regular 401(k)? You can still contribute to both a regular and a Roth 401(k), but the total amount invested yearly in the two accounts cannot exceed a combined total of $15,000 ($20,000 if you are 50 or over). You can’t switch funds back and forth between a regular and a Roth 401(k). Once the funds are in a Roth 401(k) they must stay in the Roth 401(k).
While your contributions to a Roth 401(k) are considered post-tax and the withdrawals are tax-free, employer matching funds accumulate separately and are taxed as ordinary income at withdrawal.
How Common?
A mini-survey by the Profit Sharing /401(k) Council of America (PSCA) in October 2005 showed only 17 percent of employers planned to offer a Roth 401(k). A number of employers surveyed were concerned about additional paperwork to add a Roth 401(k) plan, and the uncertainty about the future of the Roth 401(k) after 2010. But interest is growing among both employers and financial service providers.
Is a Roth 401(k) Right for You?
A Roth 401(k) plan may be attractive to younger employees with less income who may choose to pay the taxes now and enjoy tax-free withdrawals later on. Older Americans who are generally at their peak income earning years can benefit from the tax-free contributions of a regular 401(k). Then, when they pay tax on the withdrawals in retirement, their income will likely be lower and withdrawals would be taxed at a lower rate.
Then again, highly paid employees may find a Roth 401(k) attractive because, unlike the Roth IRA, there are no income limitations on a Roth 401(k). Currently, you can contribute to a Roth IRA only if your adjusted gross income is less than $110,000 for an individual and $160,000 for a couple.
In addition, workers who are strapped for cash but still want to participate in a work-based savings plan may prefer the regular 401(k). Since contributions to a Roth 401(k) are made with post-tax income, employees who contribute will see a decrease in their take-home pay as they will have to pay taxes now on their contributions.
It is not a simple decision. Many factors can influence your decision on which 401(k) option to choose. Your age, your present and future income levels, and your current and future tax situations are just some of the factors to consider. You may want to consult with a tax advisor before making a decision.
Take Action
Calculators
Need some help figuring out which 401(k) is best for you?
Check out these calculators from Smart Money.com.
AARP Resources
Retirement Accounts at Work
Learn more about 401(k) accounts.
Additional Resources
For more information on the Roth 401(k) check out these articles from Smart Money and BusinessWeek Online.
This column is meant to provide general financial information; it is not meant to substitute for, or to supersede, professional or legal advice.
Note: The content areas in this material are believed to be current as of this printing, but, over time, legislative and regulatory changes, as well as new developments, may date this material.
The National Endowment for Financial Eduction® (NEFE®) is a non-profit 501 (c) (3) foundation dedicated to helping all Americans acquire the information and gain the skills neccesssary to take control of their personal finances.
©2005 National Endowment for Financial Education. All rights reserved.
