The Roth 401(k) — a hybrid of the Roth IRA and the traditional 401(k) — made its debut on January 1, 2006 with little fanfare. This is unfortunate, because a Roth 401(k) can be a powerful tool in your — and your employees’ — retirement planning arsenal.
“A Roth 401(k) offers you and your employees another strategy to build your nest eggs,” says Scott Rittenberg, a tax shareholder at Tauber & Balser, P.C. “But before you change your current offerings, know the pros and cons of this new retirement-savings vehicle.”
Smart Business talked to Rittenberg about the differences between Roth accounts and what kind of benefits each offers.
How do Roth IRAs and Roth 401(k)s differ?
Like the Roth IRA, the Roth 401(k) provides eligible employees the opportunity to forgo a tax benefit on contributions in exchange for tax-free withdrawals during retirement. Although Roth IRA contributions aren’t permitted if your income exceeds certain limits, Roth 401(k) contributions are allowed regardless of income. So a Roth 401(k) may be especially useful to you and your top-level employees who are ineligible to contribute to a Roth IRA.
Another advantage of the Roth 401(k) over the Roth IRA is that you may contribute more to a Roth 401(k). For example, in 2006, you can contribute up to $15,000 to a traditional or Roth 401(k). If you are age 50 or older, your maximum allowable contribution increases, with the $5,000 ‘catch-up’ amount to $20,000 in 2006. You can make contributions to both types of 401(k) plans as long as your total contribution doesn’t exceed the limit. The maximum contribution for the traditional or Roth IRA is only $4,000 ($5,000 for those at least age 50) this year.
How do traditional and Roth 401(k)s differ?
Any employer match that is made based on your (or an employee’s) Roth 401(k) contributions would be deposited into your traditional 401(k) account. Why? Because distributions from the employer match portion are subject to tax, while Roth 401(k) distributions are tax-free as long as the plan is properly structured. ‘Properly structured’ means distributions are made no earlier than when the participant reaches age 59-1/2 and no sooner than five years from the date of the contribution. Also, unlike traditional 401(k) contributions, Roth 401(k) contributions don’t reduce your taxable income.
The Roth 401(k) is scheduled to expire in 2011. So unless Congress takes action, this is a limited-time offer. Many commentators believe the accounts will be permitted to continue but contributions won’t be allowed.
Are there other important differences?
Both types of 401(k)s have the same rules for distributions. That is, minimum required distributions must begin no later than April 1 of the year following the year in which you reach age 70-1/2.
But the required minimum distribution rules don’t apply if you leave the company and roll your Roth 401(k) funds into a Roth IRA. Then the Roth IRA rules apply. Unlike traditional IRAs, Roth IRAs have no minimum distribution requirements.
There are also different rules for contributions after age 70-1/2. With a traditional IRA, you can no longer make contributions once you reach age 70-1/2. That’s not the case with a Roth IRA: You can keep contributing to one as long as you meet the earned income requirements.
Take the tax break now or later?
Although the ability to take tax-free distributions at retirement is valuable, it’s vital to consider whether the advantage offsets the cost of forgoing a tax benefit today. This requires estimating what your non-401(k) taxable income will be in retirement and guessing what the tax rates will be at that time.
Are there estate planning benefits?
Understanding the rules for contributions and distributions can help you decide whether to contribute to a Roth 401(k) for estate planning purposes.
Let’s say, for instance, that you have sufficient outside income in your retirement years. With a traditional 401(k) and IRA combination, you’ll be required to make withdrawals, which will add to your tax burden and reduce your retirement account balance. But if you choose the Roth 401(k) and Roth IRA contribution, you can continue to let the funds grow and possibly make contributions.
Having a Roth 401(k) and Roth IRA together can also benefit your heirs, especially if the Roth 401(k) is rolled into a Roth IRA prior to your death. Although your beneficiaries would have to take distributions based on their life expectancies, they would pay no income tax on Roth IRA distributions.
SCOTT RITTENBERG, a tax shareholder at Tauber & Balser, P.C., has more than 15 years of public accounting experience dealing with the tax issues of small to medium-sized businesses, with an expertise in family business, tax insolvency issues and closely held businesses. Reach him at (404) 814-4974 or [email protected].