New Year's Eve revelers won't be thinking about their 401(k) plans on Dec. 31. But at the stroke of midnight comes a new option: the Roth 401(k). What sets it apart from traditional 401(k) plans is the way participants are taxed. You make your contributions with aftertax dollars, but "when you withdraw money from a Roth 401(k), it comes out tax free," says Robert Reby, a certified financial planner in Danbury, Conn. Here's a look at the issues surrounding the Roth 401(k) -- and what you should consider before you open one.
How is the Roth 401(k) different?
Unlike traditional 401(k)s, which offer tax-deferred growth, participants in a Roth 401(k) pay their taxes up front. If you put $15,000 in a traditional 401(k), you literally slice $15,000 off your taxable income for the year. Now, assume your investment grows to $45,000 over time, and your tax bracket is 33 1/3%. Because all your contributions are tax-deferred, you pay no income taxes until you take a distribution -- which can start when you reach 59 1/2. When you tap the account, you'd end up with $30,000 after taxes.
Let's use those same assumptions with a Roth 401(k): You'd need $22,500 worth of income to get that $15,000 investment, since you'd pay taxes up front ($7,500). The flip side is that you get to keep the entire $45,000 that accumulates in the account. With a Roth, "you don't get the immediate gratification, but it is a great thing for future gratification," Reby says.
Who is eligible for a Roth 401(k)?
Unlike a Roth individual retirement account, which has strict income limits, there's no velvet rope to get into a Roth 401(k). Like traditional 401(k)s, Roths have a catch-up provision. Those 50 or older by the end of 2006 can contribute up to $20,000.
Can I still get a company match?
Employer matches will still be made with pretax dollars. But the match money will accumulate in a separate account and be taxed as ordinary income at withdrawal.
What are the withdrawal rules?
Roth 401(k)s are similar to Roth IRAs in this regard -- investors must hold their account for five years before you get a tax-free withdrawal. The rules are still fuzzy, but it looks like a Roth 401(k) will be similar to a traditional 401(k): You can take an early withdrawal, but you'll pay a 10% penalty if you do so. Money can also be paid out when you terminate employment or when you reach the age of 59 1/2.
Will my company offer a Roth 401(k)?
According to a recent survey by Hewitt Associates, an employee benefits consultancy, 35% of the 198 companies that responded say they are likely to add a Roth 401(k) to their benefits plan. Yet some companies haven't focused on making it available, according to retirement consultants. "It's a bit of a hassle to offer a Roth 401(k)," says Martin Nissenbaum, Ernst & Young's national director of retirement planning. Companies need separate accounting systems to track Roth 401(k)s, so administrative costs go up. They also will need to mount educational campaigns to bring their employees up to speed. That said, major companies will have to offer a Roth 401(k) to keep their benefits competitive, Nissenbaum notes.
Is the Roth 401(k) here to stay?
The Economic Growth & Tax Relief Reconciliation Act of 2001 -- the legislation authorizing the Roth 401(k) -- expires at the end of 2010, and it's up to Congress to extend the Roth provisions. If the rules expire, investors should be able to roll accounts into a regular Roth IRA, although you won't be able to make new contributions.
Who should consider a Roth 401(k)?
Younger workers in low tax brackets should look at a Roth 401(k) because their incomes are bound to increase as their careers progress, putting them in a higher tax bracket later on. Anyone looking to shelter assets for heirs should also give it serious thought. "If you don't think you need the money for retirement, you can allow your account to build up tax free until you die," Nissenbaum says. You typically can't do that with a traditional 401(k).
By Lauren Young