The Newest Savings Opportunity
There’s a new kind of defined retirement plan on the market,
but you may have to ask your employer to add it to your
In 2001, Congress passed the Economic Growth and Tax Relief Reconciliation Act (EGTRRA), which
provided a variety of changes, adjustments and extensions to rules for retirement plans to be phased in
during the ensuing 10 years. Among those provisions was the creation of the Roth 401(k), a hybrid that
allowed contributions of after-tax dollars (like a Roth IRA) through salary deferral up to $15,000 (2006
limit) with a $5,000 catch-up allowed for people over age 50 (like a 401(k) plan.)
Roth 401(k) plans didn’t received much attention in the intervening years because that particular part of
EGTRRA didn’t take effect until January 2006 and was set to expire at the end of 2010. It was made
permanent by the Pension Protection Act of 2006. A survey conducted in early 2007 by the Profit
Sharing/401(k) Council of America showed that 22 percent of 401(k) plans offered a Roth option, and 61
percent of plans were either considering or planning to add a Roth option.
That’s not surprising. Roth 401(k)s operate on the same assumption as Roth
IRAs: that those who use them will be in a higher tax bracket after retirement
than they are now. Both Roth products are funded with after tax dollars, making
withdrawals of contributions and earnings tax free. Traditional 401(k)s and
traditional IRAs work the opposite way: dollars are contributed pre-tax or with
an attached tax deduction now, and contributions and earnings are taxed upon
withdrawal, when the employee expects to be in a lower tax bracket.
In May 2006, Congress eliminated income restrictions, which were $110,000
for individuals and $160,000 for married couples, on conversions from
traditional IRAs to their Roth counterparts. This provision, however, doesn’t
kick in until 2010. Individuals who earn more than $110,000 cannot open a
Roth IRA, although many tax and investment professionals expect the IRS to
allow those over the income limit to open Roth IRAs to receive rollovers from
the Roth 401(k)s.
A rollover may also be beneficial to someone turning 70½. At that age, Roth
401(k) accounts, traditional 401(k) accounts and traditional IRA accounts
begin minimum required distributions. A Roth IRA has no mandatory
distribution, so the money in them can continue to grow tax-free for as long
as you wish – even for the beneficiary of your Roth IRA account.
Like Roth IRAs, Roth 401(k) contributions are subject to a five-year investment
requirement, meaning that to receive distributions without penalty, the account
holder must be age 59 ½ and have held the account for five years. When
rolling funds from a Roth 401(k) to a Roth IRA –or in any other conversion –
keep careful records to verify the date you made the contributions so you can
establish the base for that five year holding period.
Many factors can affect your personal decisions about traditional versus Roth,
and 401(k) versus IRA, including your age, your tax bracket now, your expected
tax bracket in retirement, the amount you are contributing, and your ability and
desire to pass funds to future generations. An investment professional can help you weigh the pros and
cons of each account and contribution type to determine which best meets your needs.
If you are an employer, your investment and tax professionals can help you decide whether adding the
Roth 401(k) contribution provision to your plan – a relatively simple and low-cost change – makes sense
for you and your employees.
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