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New Tax-Free Savings Option -- The Roth 401(k)
Barry C. Picker, CPA/PFS, CFP
Picker & Weinberg, CPAs, PC
[align=left] oth IRAs have been available for building up tax-free retirement funds since 1998. But starting in January 2006, the particular tax-free aspects of Roth IRAs will be extended to 401(k)s, creating a brand-new retirement savings vehicle -- the Roth 401(k). Traditional 401(k)s and Roth IRAs will continue to be available, as before.[/align]
Recent proposed IRS regulations provide some important details.
An Overview
Up to now, the basic practical difference between 401(k)s and Roth IRAs has been that with a 401(k), salary contributions and appreciation are tax deferred while withdrawals are taxable... and with a Roth IRA, contributions are made with after-tax dollars, and under certain circumstances, withdrawals are tax free. Starting next year, if a 401(k) plan offers a Roth option, then a participant will be able to put some -- or all -- of his/her annual contributions into a separate account designated as a Roth. The portion of total contributions that goes to this account will be taxable to the participant as current compensation. But if the funds are held for a required time (discussed below), withdrawals will be entirely tax free. What you should know...
Contribution limit. The maximum amount that can be contributed to a Roth 401(k) each year will be the same as for a regular 401(k). In 2006, this limit will be $15,000, or $20,000 for those age 50 and older by the end of the year. The Roth IRA income limits to making contributions do not apply to Roth 401(k)s.
Strategy: Participants will be able to split their 401(k) contributions between a traditional and Roth 401(k). For example, a participant may decide to put $10,000 into a traditional 401(k) to obtain tax deferral on this portion of salary, while contributing $5,000 to a Roth 401(k) for future tax-free income.
Separate accounts required. Funds must be held in separate accounts for regular and Roth 401(k) contributions. This will mean a little more effort on the part of participants to coordinate and track investments in the two accounts.
Important: Where companies provide matching contributions, they cannot be made to the Roth 401(k), but instead have to be allocated to the regular 401(k).
Tax-free withdrawals. Like Roth IRAs, funds in Roth 401(k)s will be available for tax-free withdrawal if they are held more than five years and are taken after age 59 [suP]1[/suP]/[suB]2[/suB], or because of disability or death, or to use for up to $10,000 in first-time home-buying expenses.
Rollovers. When employees leave the job, they can roll over funds from a Roth 401(k) into a Roth IRA. This means that departing employees will have two potential rollovers when they leave their jobs -- one for rollover funds from a regular 401(k) to a traditional IRA and the second rollover for funds from a Roth 401(k) to a Roth IRA.
Caution: Unlike IRAs that can be converted to Roth IRAs, funds from a regular 401(k) cannot be converted to a Roth 401(k).
Distributions. In contrast to Roth IRAs that have no lifetime distribution requirements, funds in a Roth 401(k) are subject to mandatory lifetime distribution rules. This generally means that withdrawals must commence at age 70 [suP]1[/suP]/[suB]2[/suB].
Is a Roth 401(K) for You?
To obtain future tax-free treatment available from the Roth 401(k), a person must give up the current tax-deferral benefit. Not everyone will be willing to do this, despite the potential big payoff. Who should consider this new option...
Younger workers. Those with a long time until retirement may be willing to sacrifice current tax deferral for future tax-free income. They will have many years to build up a retirement fund that will generate tax-free income.
Low-tax-bracket taxpayers with bright futures. Those who are in lower tax brackets do not save much in taxes by opting for current deferral. They may be better off with a Roth 401(k) so that future withdrawals will be tax free when they presumably will be in higher tax brackets.
Higher-income taxpayers closed out of Roth IRAs. Maximum contributions to Roth IRAs are limited to taxpayers with adjusted gross incomes (AGIs) below $95,000 ($150,000 on a joint return). The annual contribution limit starts falling for those with AGI above these limits and reaches zero for those with AGI above $110,000 ($160,000 on a joint return). With Roth 401(k)s, there are no AGI limits.
Those betting on higher tax rates in the future. These taxpayers might want to gamble on future tax-free income from a Roth 401(k).
Generally, Roth 401(k)s are not suitable for workers within five years of age 70 [suP]1[/suP]/[suB]2[/suB], or those close to retirement at a younger age, when funds from the account will be needed to live on.
Reason: The accounts will not have time to qualify for tax-free-withdrawal treatment.
What To Do Now
Small-business owners and self-employed individuals should decide whether to set up Roth 401(k)s.
Employees should be alert to whether their employers will be offering Roth 401(k)s next year. Roth 401(k)s can also be set up by 403(b) plans used by schools and charities, but not by 457 government plans.
Note: Companies are not required to expand their 401(k)s to include the Roth option, and it remains to be seen which will act upon this option.
If employees learn in the coming months that they will be able to make Roth 401(k) contributions, they should work with a financial adviser to decide whether, and the extent to which, they will take advantage of this opportunity next year.
Unanswered Questions
The proposed regulations do not address every concern about the operation of the new accounts. One of the key outstanding questions is what will happen to Roth 401(k)s after 2011, when the law authorizing them is set to expire.
Expiration wouldn't hurt funds already in a Roth 401(k), but no new contributions would be permitted. The possibility of expiration is a fact that may keep some companies from jumping on the Roth 401(k) bandwagon -- they won't want to incur the cost of amending plan documents for a short-term arrangement.
New Tax-Free Savings Option -- The Roth 401(k)
Barry C. Picker, CPA/PFS, CFP
Picker & Weinberg, CPAs, PC
[align=left] oth IRAs have been available for building up tax-free retirement funds since 1998. But starting in January 2006, the particular tax-free aspects of Roth IRAs will be extended to 401(k)s, creating a brand-new retirement savings vehicle -- the Roth 401(k). Traditional 401(k)s and Roth IRAs will continue to be available, as before.[/align]
Recent proposed IRS regulations provide some important details.
An Overview
Up to now, the basic practical difference between 401(k)s and Roth IRAs has been that with a 401(k), salary contributions and appreciation are tax deferred while withdrawals are taxable... and with a Roth IRA, contributions are made with after-tax dollars, and under certain circumstances, withdrawals are tax free. Starting next year, if a 401(k) plan offers a Roth option, then a participant will be able to put some -- or all -- of his/her annual contributions into a separate account designated as a Roth. The portion of total contributions that goes to this account will be taxable to the participant as current compensation. But if the funds are held for a required time (discussed below), withdrawals will be entirely tax free. What you should know...
Contribution limit. The maximum amount that can be contributed to a Roth 401(k) each year will be the same as for a regular 401(k). In 2006, this limit will be $15,000, or $20,000 for those age 50 and older by the end of the year. The Roth IRA income limits to making contributions do not apply to Roth 401(k)s.
Strategy: Participants will be able to split their 401(k) contributions between a traditional and Roth 401(k). For example, a participant may decide to put $10,000 into a traditional 401(k) to obtain tax deferral on this portion of salary, while contributing $5,000 to a Roth 401(k) for future tax-free income.
Separate accounts required. Funds must be held in separate accounts for regular and Roth 401(k) contributions. This will mean a little more effort on the part of participants to coordinate and track investments in the two accounts.
Important: Where companies provide matching contributions, they cannot be made to the Roth 401(k), but instead have to be allocated to the regular 401(k).
Tax-free withdrawals. Like Roth IRAs, funds in Roth 401(k)s will be available for tax-free withdrawal if they are held more than five years and are taken after age 59 [suP]1[/suP]/[suB]2[/suB], or because of disability or death, or to use for up to $10,000 in first-time home-buying expenses.
Rollovers. When employees leave the job, they can roll over funds from a Roth 401(k) into a Roth IRA. This means that departing employees will have two potential rollovers when they leave their jobs -- one for rollover funds from a regular 401(k) to a traditional IRA and the second rollover for funds from a Roth 401(k) to a Roth IRA.
Caution: Unlike IRAs that can be converted to Roth IRAs, funds from a regular 401(k) cannot be converted to a Roth 401(k).
Distributions. In contrast to Roth IRAs that have no lifetime distribution requirements, funds in a Roth 401(k) are subject to mandatory lifetime distribution rules. This generally means that withdrawals must commence at age 70 [suP]1[/suP]/[suB]2[/suB].
Is a Roth 401(K) for You?
To obtain future tax-free treatment available from the Roth 401(k), a person must give up the current tax-deferral benefit. Not everyone will be willing to do this, despite the potential big payoff. Who should consider this new option...
Younger workers. Those with a long time until retirement may be willing to sacrifice current tax deferral for future tax-free income. They will have many years to build up a retirement fund that will generate tax-free income.
Low-tax-bracket taxpayers with bright futures. Those who are in lower tax brackets do not save much in taxes by opting for current deferral. They may be better off with a Roth 401(k) so that future withdrawals will be tax free when they presumably will be in higher tax brackets.
Higher-income taxpayers closed out of Roth IRAs. Maximum contributions to Roth IRAs are limited to taxpayers with adjusted gross incomes (AGIs) below $95,000 ($150,000 on a joint return). The annual contribution limit starts falling for those with AGI above these limits and reaches zero for those with AGI above $110,000 ($160,000 on a joint return). With Roth 401(k)s, there are no AGI limits.
Those betting on higher tax rates in the future. These taxpayers might want to gamble on future tax-free income from a Roth 401(k).
Generally, Roth 401(k)s are not suitable for workers within five years of age 70 [suP]1[/suP]/[suB]2[/suB], or those close to retirement at a younger age, when funds from the account will be needed to live on.
Reason: The accounts will not have time to qualify for tax-free-withdrawal treatment.
What To Do Now
Small-business owners and self-employed individuals should decide whether to set up Roth 401(k)s.
Employees should be alert to whether their employers will be offering Roth 401(k)s next year. Roth 401(k)s can also be set up by 403(b) plans used by schools and charities, but not by 457 government plans.
Note: Companies are not required to expand their 401(k)s to include the Roth option, and it remains to be seen which will act upon this option.
If employees learn in the coming months that they will be able to make Roth 401(k) contributions, they should work with a financial adviser to decide whether, and the extent to which, they will take advantage of this opportunity next year.
Unanswered Questions
The proposed regulations do not address every concern about the operation of the new accounts. One of the key outstanding questions is what will happen to Roth 401(k)s after 2011, when the law authorizing them is set to expire.
Expiration wouldn't hurt funds already in a Roth 401(k), but no new contributions would be permitted. The possibility of expiration is a fact that may keep some companies from jumping on the Roth 401(k) bandwagon -- they won't want to incur the cost of amending plan documents for a short-term arrangement.
