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Ask About Roth 401(k) Retirement Plans

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By | May 20, 2012

Dear Toolkit,

What's the skinny on the new type of retirement plan known as a Roth 401(k)?

Thanks,

Short N. Sweet

Dear Short N. Sweet,

Although your question is true to your name, we fear my answer may be neither short nor particularly sweet. We 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 regular 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 rule applies to them as to Roth IRAs. Roth 401(k) "qualified" distributions 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 A Roth 401(k) election cannot be rescinded.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 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
2013
none $188,000 married;
$127,000 single
none
Max. Contribution
2013
$17,500 
$23,000 for those
over age 50
$5,000
$6,000 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 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. A Roth election, being an after tax deduction, can lower your take home pay significantly.

Here's a link to a great interactive calculator that compares a Roth to a traditional 401(k).

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