By Alice Magos, CCH Toolkit Staff Writer
On June 7, 2001, Congress enacted the Economic Growth and Tax Relief Reconciliation Act (EGTRRA) and the sun rose on a new type of elective retirement plan, which took effect as scheduled on January 1, 2006. And unless Congress extends the Roth 401(k) provisions, the sun will set on them December 31, 2010.
Proposed regulations, comments and revisions bounced back and forth for months and in January 2006 the final guidance was published. Here's the original IRS document for anyone who's really hard up for something to do with their spare time. For the rest of you, I will attempt to boil this confusion down to its essentials.
To begin with, a Roth 401(k) is an add-on to a regular 401(k). (These same regs apply to the new Roth 403(b) plan option.) An employer offering a traditional 401(k) can choose to tack on a Roth election. . .or not. It will entail a lot of extra work for the plan administrator since the plan design will need to be amended and Roth contributions must be kept in separate accounts from traditional 401(k) contributions. The reason for this is that traditional 401(k) contributions are pre-tax and distributions are taxable whereas Roth contributions are after-tax and distributions are tax-free.
There are no income limitations with a Roth 401(k) and they permit higher contributions, unlike Roth IRAs.And the same 5 year holding rule applies to them as to Roth IRAs. Roth 401(k) "qualified" distribution events include death, age 59-1/2 and disability. A Roth 401(k) election cannot be rescinded. . .you elect it, you're stuck with it. But it can be rolled over into a Roth IRA (although the five-year rule will apply all over again.) But the reverse is a no-no. You can't roll a Roth IRA into a Roth 401(k). And Roth 401(k)s are not compatible with SEPs or Simple plans. The IRS offers this excellent resource on rollovers, if you crave the gory details.
The question for the employee who is considering electing a Roth is "do I pay now or pay later?" Do you think your income and tax bracket will be lower at retirement than it is at present? My personal opinion is that taxes will likely rise over the coming years due to the deficit and the Social Security and Medicare problems that may require subsidy. Based on that assumption, a high earner today would benefit greatly from taking advantage of a Roth 401(k) now since his contributions would be at a lower tax rate than the forecast for future years and will compound and distribute on a tax free basis. But your decision to elect a Roth 401(k) will depend on your individual analysis of what the economic future may be, your age, your current earnings, expenses and tax bracket, your expected career path and so forth.
Here's a quick comparison chart:
| Comparing Retirement Plan Options
|
| Topic |
Roth 401(k) |
Roth IRA |
Traditional 401(k) |
| Contributions |
after-tax dollars |
after-tax dollars |
pre-tax dollars |
| Income Limits |
none |
$160k married; $110k single |
none |
| Max. Contribution |
$15k; $20k for those over age 50 |
$4k or $5k over 50 |
same as Roth 401(k) |
| Tax on distributions |
none if held 5 years and qualified |
same as Roth 401(k) |
federal and state taxed |
| Distribution Limits |
Age 70.5 |
none |
Age 70.5 |
Only time will tell if this new option will be widely adopted. Very large firms will no doubt have to amend their current plans to include the Roth election in order to be competitive in the labor market. For smaller firms the administrative cost and burden might prove to be too high. If you're a late career, high earner it seems like a great opportunity to accumulate at least 5 years worth of contributions (not needed for current expenses) and let them compound as long as you wish. Qualified distributions will be tax free except for any employer-matching funds, which are required to go into the traditional (taxable) part of the 401(k) plan.
Keep in mind that the rules and regulations may continue to change and evolve over time as the IRS sees fit. And of course Congress can always sunset this election earlier than 2010 or extend it into infinity or change the details of the law in some unforeseen way. Your crystal ball is probably as good as mine for predicting future pitfalls. You could hedge the risk and put half of your contributions in the traditional account and half in the Roth account every year. If you're a youngish, early or mid career individual with a family, a mortgage and college expenses looming, you probably should think twice before spreading yourself too thin by participating in a Roth 401(k) just because it may be offered by your employer.
- Related items:
- New Retirement Savings Opportunities in Recent Tax Relief Law
- Congress Extends Tax Relief Provisions with Offsets, Seeks To Reinstate Expired Credits
- Supreme Court Rules IRAs Exempt from Bankruptcy Estate
Added to the news on August 16, 2006.
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