The Roth 401(k) is a type of retirement savings plan. It was authorized by the United States Congress under the Internal Revenue Code, section 402A , and represents a unique combination of features of the Roth IRA and a traditional 401(k) plan. As of January 1, 2006 U.S. employers have been free to amend their 401(k) plan document to allow employees to elect Roth IRA type tax treatment for a portion or all of their retirement plan contributions. The same change in law allowed Roth IRA type contributions to 403(b) retirement plans. The Roth retirement plan provision was enacted as a provision of the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA 2001).
Traditional 401(k) and Roth IRA plans
In a traditional 401(k) plan, introduced by Congress in 1978, employees contribute pre-tax earnings to their retirement plan, also called “elective deferrals“. That is, an employee’s elective deferral funds (currently up to $15,500 per tax year for those under age 50 and $20,500 for those over) are set aside by the employer in a special account where the funds are allowed to be invested in various options made available in the plan.
Employers may also add funds to the account by contributing matching funds on a fractional formula basis (e.g., matching funds might be added at the rate of 50% of employees’ elective deferrals), or on a set percentage basis. Funds within the 401(k) account grow on a tax deferred basis. When the account owner reaches the age of 59-and-a-half, they may begin to receive “qualified distributions” from the funds in the account; these distributions are then taxed at ordinary income tax rates. Exceptions exist to allow distribution of funds before 59 and a half, such as Substantially equal periodic payments, disability, and separation from service after the age of 55, as outlined under IRS Code section 72(t).
Under a Roth IRA, first enacted in 1998, individuals, whether employees or self-employed, voluntarily contribute post-tax funds to an individual retirement arrangement(IRA). In contrast to the 401k plan, the Roth plan requires post-tax contributions, but allows for tax free growth and distribution, provided the contributions have been invested for at least 5 years and the account owner has reached age 59 and a half. The amounts of income that can be invested in a Roth IRA are significantly more limited than those to a 401(k) are. For 2008, individuals are limited to contributing no more than $5,000 to a Roth IRA, if under age 50, and $6,000, if age 50 or older. Additionally, Roth IRA contributions are prohibited when taxpayers earn a Modified Adjusted Gross Income of more than $110,000, ($160,000 for married filing jointly). Here is a 401(k) versus IRA matrix that compares various types of IRAs with various types of 401(k)s.
The Roth 401(k) plan
The Roth 401(k) combines some of the most advantageous aspects of both the 401(k) and the Roth IRA. Under the Roth 401(k), employees can decide to contribute funds on a post-tax elective deferral basis, in addition to, or instead of, pre-tax elective deferrals under their traditional 401(k) plans. An employee’s combined elective deferrals– whether to a traditional 401(k), a Roth 401(k), or to both– cannot exceed $15,500 for tax year 2008 if a participant is under 50; if they are over 50, they may contribute an additional $5,000. Employer’s matching funds are not included in the $15,500 elective deferral cap, but are considered for the maximum section 415 limit, which is $46,000 for 2008. Employers are permitted to match contributions to a designated Roth account, but the matching funds must be made on a pre-tax basis, not be made into the designated Roth account, and cannot receive the Roth tax treatment. (Pub 4530)
In general, the difference between a Roth 401(k) and a traditional 401(k) is that the Roth version is funded with after-tax dollars while the traditional 401(k) is funded with pre-tax dollars. After-tax dollars represent money for which taxes are paid in the current year, and pre tax dollars are those which do not represent federal taxable income in the current year. Typically, the earnings on Roth contributions will be tax free as long as the distribution is made at least 5 years after the first Roth contribution and the attainment of age 59 and one half, unless an exception applies.
A Roth 401(k) plan will probably be most advantageous to those who might otherwise choose a Roth IRA, for example, younger workers who are currently taxed in a lower tax bracket, but expect to be taxed in a higher bracket upon reaching retirement age. The Roth 401(k) offers the advantage of tax free distribution, but is not constrained by income limitations. For example, normal Roth IRA contributions are limited to $5,000; whereas, up to $15,500 could be contributed to a Roth 401(k) account, provided no other elective deferrals were taken for the tax year (no traditional 401(k) deferrals taken).
Adoption of Roth 401(k) plans has been relatively slow, and stated reasons for this include the fact that they require additional administrative recordkeeping and payroll processing. However some larger firms have now adopted Roth 401(k) plans, and this is expected to spur their adoption by other firms including smaller ones.
- Roth 401(k) contributions are irrevocable, such that once money is invested into a Roth 401(k) account; it cannot be moved to a regular 401(k) account.
- Employees are able to roll their Roth 401(k) contributions over to a Roth IRA account upon termination of employment.
- It is the employer’s decision as to whether the company will provide access to the Roth 401(k) in addition to the traditional 401(k). Many employers may feel that the added administrative burden outweighs the benefits of the Roth 401(k)
- The Roth 401(k) plan will now be available after December 31, 2010 since the Pension Protection Act of 2006 was passed to extend the program. The program was originally set up to sunset, or no longer be in place, after 2010 along with the rest of EGTRRA 2001.
- Unlike Roth IRAs, owners of Roth 401(k) accounts (designated Roth accounts) must begin distributions upon reaching age 70 and a half, similar to required minimum distributions for IRA and other retirement plans. (Pub 4530)
- 401(k) IRA matrix – 401k & IRA comparisons (401k vs Roth 401k vs Traditional IRA vs Roth IRA)