In 2006, another option was added to the retirement plan landscape: the Roth 401(k). As the name infers, it's a hybrid of the traditional 401(k) and the Roth IRA. To determine if the Roth 401(k) should become part of your employer-sponsored retirement plan, let's take a closer look.
Workers contribute to the Roth 401(k) through payroll deductions with after-tax dollars. However, the account grows tax-free. And any withdrawals made during retirement aren't subject to income tax or penalties if the person is at least 59 1/2 years old and has held the account for five years or more.
Comparison to its "cousins"
The Roth 401(k) and its predecessors have similarities and differences. Like the Roth 401(k), contributions to a Roth IRA plan are made with after-tax dollars and grow without any tax consequences. Conversely, with a traditional 401(k), employees receive the tax deduction up front, contributing before-tax dollars. However, withdrawals taken during retirement are subject to income tax.
All three plans have contribution limits, as shown here for 2009: The ceiling for Roth IRA contributions is $5,000, or $6,000 for people age 50 or older. Traditional 401(k) and Roth 401(k) contributions are limited to $16,500 for people 49 or younger and $22,000 for those older than 50. While employees can divide money between the two types of plans, the limits apply to both rather than each one separately. (You can't save $16,500 in each.)
The Roth IRA has income restrictions: Eligibility for 2009 phases out between $105,000 and $120,00 for single tax filers and between $166,000 and $176,000 for married couples who file jointly. No one is prohibited from participating in a Roth 401(k) based on their adjusted gross income.
Employer matching varies among plans, too. With traditional 401(k) plans, employers can make contributions on behalf of employees, make matching contributions based on employees' elective deferrals or both. With a Roth 401(k), employer matches are made with pre-tax dollars. The matching money accrues in a separate account that is taxed as ordinary income at withdrawal. As an individual retirement plan, the Roth IRA is not an employer-sponsored plan subject to matching.
Choosing between plans
If you opt to offer the Roth 401(k), workers may have a tough decision to make: Should they contribute to the new plan and accept the cut in take-home pay or opt for a traditional 401(k), hoping their retirement tax rate will be lower than it is now? Or should they hedge their bets and divide money among both plans?
Conventional wisdom says that people in their peak earning years whose tax bracket will be lower in retirement should stick with a traditional 401(k). But the choice isn't simple. No one has a crystal ball that shows for sure what tax rates will be in the future. Yet many experts believe that costs associated with Social Security, Medicare and the growing budget deficit will lead to increased taxes.
The Roth 401(k) is advantageous for high net worth business owners and highly compensated employees who are typically prohibited from contributing to Roth IRAs because of income restrictions. In addition, employees who plan to continue working for a long time may benefit from the tax-free savings inherent in the Roth 401(k) plan as their accounts have more time to grow. And people just starting their careers, who will likely move into a higher tax bracket later, should consider the Roth 401(k).
But the lure of socking away pre-tax dollars in a traditional 401(k) is too great for some. "Those who believe that one should never pass up an opportunity to save taxes should consider that most of us simply do not save the dollars resulting from the tax deduction," cautions Barry Milberg of Milberg Consulting LLC, a Blue Bell, Pa., firm that offers retirement planning advice and services to small businesses.
Before you add the Roth 401(k) to your company's benefits, there are a few other factors to consider. Milberg says the plan's service provider must be positioned to provide certain services unique to the Roth 401(k), including:
- The ability to add the Roth 401(k) feature to a new or existing plan. This must be in writing in the plan documents, distribution forms and communications materials;
- The capability to withdraw after-tax Roth 401(k) employee deferrals from their pay checks;
- The capability to receive and record separate accounts for pre-tax and Roth money types;
- Knowledge of the rules pertaining to Roth 401(k) withdrawals for loans and hardship;
- Knowledge of the rules pertaining to Roth 401(k) distributions for retirement, disability and death; and
- The capability to report Roth 401(k) related information to government agencies.
- Milberg adds that the subject of Roth versus pre-tax plans confuses many people—and their financial advisors. Be sure to educate employees and provide lots of guidance if you choose to add the Roth 401(k).