An Introduction To The Roth 401(k)

By James E. McWhinney AAA

The Roth 401(k) account, funded with after-tax money, entered the retirement community in 2006. This investing innovation was created by a provision of the Economic Growth and Tax Relief Reconciliation Act of 2001. Modeled after the Roth IRA, the Roth 401(k) gives investors the opportunity to fund their accounts with after-tax money. Investors will receive no tax deduction on contributions to a Roth 401(k), but they will owe no taxes on qualified distributions. Participants in 403(b) plans are also eligible to participate in a Roth account.

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Advantages to the New Plan
The benefits associated with the Roth 401(k) depend largely on your point of view. From the government's perspective, the Roth 401(k) generates current revenue in the form of tax dollars. A comparison with the mechanics of a Traditional IRA clarifies this point.

When an investor puts money into a Traditional IRA, he or she gets a tax deduction on the contribution, if eligible. Thanks to this deduction, money that would ordinarily be lost to the tax man remains in the account, tax deferred, until it is withdrawn. From the investor's perspective, it is hoped that the account will grow over time, and that the money that would have been lost to the tax man will spend all of those years working for the investor instead. The government wants those assets to grow too because the tax deferral ends when the money is withdrawn from the account. In essence, the government gives you a tax break today in the hope that there will be even more money to tax in the future.

The Roth 401(k) works in reverse. The money that you earn today is taxed today. When you put this after-tax money into your Roth 401(k), withdrawals taken after you reach age 59.5 will be tax-free if the account has been funded for at least five years. The prospect of tax-free money during retirement is attractive to investors. The prospect of tax dollars getting paid today instead of being deferred is attractive to the government. In fact, it's so attractive that law makers have had discussions about eliminating traditional tax-deductible IRAs and replacing them with accounts such as the Roth 401(k) and Roth IRA.

New Rules
Unlike the Roth IRA, which has income limitations that restrict some investors from participating, there are no such limits on the Roth 401(k). Investors have the opportunity to contribute to a Roth 401(k), a traditional 401(k), or a combination of the two. If you choose to contribute to both, you do not get to contribute twice as much money, as contribution limits remain the same regardless of whether you choose a traditional account, a Roth, or both. The contribution limit for 2013 is currently set at $17,500 for people under age 50 and $23,000 for those 50 and above. (For more insight, see Roth, 401(k), 403(b): Which Is Right For You?)

The decision regarding which plan to choose will depend largely on your personal financial situation. If you expect to be in a higher tax bracket after retirement than you are in your working years, the Roth 401(k) may be the way to go because it will provide tax-free withdrawals when you retire. While it may seem intuitive that most investors will experience a decrease in the tax rate upon retirement, this is not necessarily so because retirees often have fewer tax deductions, and the impact of future legislation could result in higher tax rates.

Because of the uncertainty of tax rates in the future, it is wise for taxpayers currently facing lower tax rates, such as young workers, to invest in after-tax programs such as the Roth 401(k), essentially locking in the lower tax rate.

Factors in the Decision-Making Process
Prior to making a decision about which option to choose, there are a number of factors to consider. The first is that offering the Roth 401(k) is voluntary for employers. In order to offer such a plan, employers must set up a tracking system to segregate Roth assets from the company's current plan. This may be an expensive proposition, and your employer may choose not to do it. The second thing to consider is that, even if you do contribute, any matching contributions your employer makes must be deposited into a traditional 401(k) account.

Another item to consider is that, unlike with Roth IRAs, Roth 401(k) participants are subject to required minimum distributions at age 70.5. This forces investors to take distributions even if they don't need or want them. While this distribution requirement can be avoided by rolling over to a Roth IRA, it is an administrative hassle, and legislators may change the rules at any time to forbid such transfers. Keep in mind that assets held in a traditional 401(k) account cannot be converted into a Roth 401(k). Finally, you should assess your current tax rate versus your expected tax rate in the future before making your decision. As we mentioned before, if your tax rate now is lower than what it is expected to be in the future, you should use after-tax plans like the Roth 401(k). On the other hand, if your tax rate is likely to be lower in retirement, tax-deferred programs are probably a better option. (For further reading, see Tax Treatment of Roth IRAs.)

The Future of the Roth 401(k)
Like all provisions of the Economic Growth and Tax Relief Reconciliation Act of 2001, the Roth 401(k) came with an expiration date, which provided that the ability to contribute to a Roth 401(k) would expire at the end of 2010. However, the Pension Protection Act of 2006 (PPA) made the Roth 401(k) permanent.

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