Meet the New Roth 401(k)
You may think that Americans don’t need yet another type
of tax-favored retirement plan, but Congress knows better. Starting now—January
2006—Roth 401(k)s can be made available to employees and self-employed
persons.
A Roth 401(k) must combine the key features of a Roth IRA and a
401(k), right? Yes, generally, but with modifications. Here’s
what happens:
In a 401(k), the employer sets up a plan through
which employees make pre-tax contributions (“elective deferrals”)
from their pay. The amount contributed (up to a $15,000 ceiling
in 2006) is not subject to current income tax—meaning that
currently taxable pay is reduced by the amount contributed. Investment
earnings on contributions grow tax-free until withdrawn. Withdrawal,
in prescribed minimum annual amounts, is required, generally starting
at age 70½. Withdrawals may be spread over the employee’s
lifetime and, for balances at the employee’s death, over the
lifetime of a beneficiary. Spreading withdrawals over as long a
period as possible continues the tax shelter for contributions and
earnings not yet withdrawn.
 Note:
401(k)s may be used in the same way by self-employed persons, who contribute
a portion of business earnings rather than salary.
Roth IRAs are like other (traditional) IRAs in that investments
grow tax-free while in the IRA. Major differences, from traditional
IRAs and 401(k)s, are these:
Roth IRA contributions are always after-tax, never deductible. But
Roth IRA withdrawals are tax free, if made after the Roth IRA has
existed 5 years and after the owner has reached age 59½.
Roth IRA contributions are allowed up to $4,000 a year (2006 amount),
where the owner’s modified adjusted gross income (MAGI) is
less than $95,000 ($150,000 on a joint return). The $4,000 limit
is reduced by the amount of traditional IRA contributions that year.
Partial Roth contributions are allowed for MAGIs between $95,000--$110,000
($150,000--$160,000 on a joint return), but none where MAGIs are
higher.
There’s no requirement that the Roth IRA owner take withdrawals
at age 70½ or any other age. Thus, the Roth IRA owner can
pass a sizable tax-free investment to his or her heirs (beneficiaries).
They must withdraw required minimum amounts annually over their
lifetimes, but amounts withdrawn are free of income tax. As with
traditional IRAs and 401(k)s, amounts not withdrawn continue to
grow tax-free.
Note: A Roth IRA can be augmented by a rollover, in a taxable
transaction, from a traditional IRA.
Creating a Roth 401(k)
Employers may choose to make a Roth 401(k) an option to their regular
401(k) plan. The employee participant may then decide to direct
any or all of his or her elective deferral to the Roth 401(k) account
up to a ceiling of $15,000 (2006 amount) minus any amount going
into the regular 401(k). The amount going into the Roth 401(k) is
not tax-deferred; it is included in currently taxable pay. The employer
must keep regular and Roth 401(k) amounts separate.
Note:
The $15,000 ceiling may be reduced where rank-and-file employee participation
in the 401(k) (regular and Roth combined) is low.
Special Roth 401(k) Advantages
- Roth IRA funds tend to build slowly because of the relatively
low ($4,000) contribution ceiling. Roth 401(k)s, with a much higher
ceiling ($15,000), can grow much faster.
- With a Roth 401(k), there’s no income ceiling on the right
to contribute (unlike the $110,000/$160,000 ceiling for Roth IRAs).
TIP: One can have both a Roth IRA and a Roth 401(k).
A Roth 401(k) Drawback
Unlike the case with Roth IRAs, a Roth 401(k) owner must take withdrawals
from the 401(k) under the same rules that apply to regular 401(k)s
and traditional IRAs—generally starting at age 70½.
This would tend to mean smaller amounts passing tax-free to heirs.
TIP:
As rules now stand, a Roth 401(k) owner can avoid the required
minimum withdrawal rules for his or her lifetime by rolling Roth
401(k) amounts over to a Roth IRA—which imposes no minimum
withdrawal on the original owner.
Over Age 50. Persons over age 50 are allowed to
make additional “catch up” contributions on their own
behalf. For regular and Roth 401(k)s, the 2006 catch-up amount is
a total $5,000: pre-tax in regular 401(k)s and after-tax in Roths.
An amount contributed to one type of 401(k) -- say, $3,500 into
a regular 401(k) -- correspondingly reduces the ceiling for the
other type (here, to $1,500 for the Roth).
For traditional and Roth IRAs, the 2006 catch up amount is total
$1,000, with contribution to one account reducing dollar-for-dollar
the allowable contribution to the other.
Employer Matches. Employers often match employee
401(k) contributions, to some degree, such as one dollar from the
employer for every three from the employee. Employer matches of
employee Roth 401(k) contributions are not currently taxed to the
employee. They would go into the employee’s regular 401(k)
and would be taxable when distributed.
Note:
Roth 401(k)s, like regular 401(k)s, are fully available to self-employed
persons, whether or not they have employees.
TIP:
Congress thought it was doing prospective retirees a favor when
it enacted the Roth 401(k). Despite the added complexities for employers,
employees and self-employeds, it might be right for you. Consult
your tax or financial adviser.
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