New Roth 401(k) Option To Launch In 2006
The Roth 401(k), a new type of qualified retirement plan that will become available starting in 2006, may prove to be an attractive benefit option for companies employing highly compensated individuals not eligible to contribute to a Roth IRA, or younger workers who expect to be in a higher tax bracket when they retire.
As the name suggests, the Roth 401(k) incorporates elements of both traditional 401(k) plans and the Roth IRA. Included in the Economic Growth and Tax Relief Reconciliation Act (EGTRRA) of 2001, and slated to arrive January 1, 2006, the Roth 401(k) will allow workers to make Roth IRA-type contributions to 401(k) plans without Roth IRA income restrictions and contribution limits.
Roth IRA contributions are nondeductible, but earnings within the account accumulate tax free, and qualifying distributions are also tax free. Currently, only taxpayers with adjusted gross incomes below $110,000 a year for singles, and $160,000 a year for married couples, are eligible to contribute after-tax dollars to a Roth IRA. These income limits disappear under the Roth 401(k) rules.
Workers will also have the opportunity to save far more money in the new accounts than they could using a Roth IRA. The 2006 annual contribution limits for IRAs of all kinds are set at $4,000 for taxpayers under the age of 50, and $5,000 for older workers. The Roth 401(k), by contrast, will be subject to the more generous elective salary deferral limits that apply to conventional 401(k)s, which, for 2006, are $15,000 for taxpayers under the age of 50, and $20,000 for older people.
The Roth 401(k) has other advantages over the Roth IRA. Contributions are made through payroll deductions, rather than through separate arrangements with a bank. Because employers will administer these plans, contributing to them should be more convenient for workers than opening an IRA. An employee currently contributing to a traditional 401(k) plan could, for example, simply opt to have contributions diverted to a Roth version of the same plan.
Lawmakers have stipulated, however, that matching contributions made by employers must be invested in a traditional 401(k)—not a Roth—account. This means that, even if employees make all of their contributions exclusively to a Roth 401(k) account, they would still owe tax in retirement on withdrawals from funds contributed on a pre-tax basis by their employers.
Workers should also be aware that the 401(k) annual contribution limits apply to all 401(k) contributions, regardless of whether they are made on a pre-tax or after-tax basis. If employees contribute to a Roth 401(k), they may have to reduce or discontinue their contributions to their employer’s conventional 401(k) plan to avoid exceeding these limits. Provided they remain within these limits, however, employees are allowed to put money into both types of 401(k) plans.
In addition, employees considering the Roth 401(k) option should know that—like the 401(k), but unlike the Roth IRA—the Roth 401(k) will require them to begin taking distributions after the age of 70½. On the other hand, the Roth 401(k) resembles the Roth IRA in that investors will not be permitted to withdraw their money tax free until they have held the account for at least five years, and are at least 59½ years old. The latter provision could make the Roth 401(k) less attractive to employees who are currently approaching retirement.
It also remains far from clear whether most employers who sponsor 401(k) plans will add the Roth 401(k) option to their plans as of January 1, 2006. To add to the confusion, questions linger about whether the Roth 401(k) will continue to be available after the EGTRRA provisions expire in 2010.
In a recent EBN QuickPoll survey of retirement plan sponsors, 13% of respondents said they expect to add the Roth 401(k) to their benefits package, 32% are considering doing so, and 48% do not intend to offer the accounts. But because the Internal Revenue Service may not issue final rules on Roth 401(k)s before January, some plan sponsors may wait until next year before deciding whether to add this option to their retirement packages.
