Roth 401(k) Accounts

The Economic Growth and Tax Relief Reconciliation Act of 2001 added a new section to the Internal Revenue Code that provides for designated Roth contributions to 401k plans.  Employers may begin offering these plans in 2006

In March, 2005.the IRS proposed rules for this new type of account which combines features of Roth IRAs with features of 401(k) plans. Employers can offer the new accounts as an option in their regular 401(k).

In a regular 401(k) plan, contributions are made with before-tax dollars. The money is not taxed while it remains in the account, but every dollar taken out is taxed as ordinary income.

Contributions to a Roth 401(k) will be made with after-tax dollars, so initially they won't reduce an employee’s tax bill.  However, the money will grow tax-free, and all withdrawals after age 59 1/2 will be tax-free.  In other words, a regular 401(k) plan gives you a tax break on the front end while the Roth 401(k) gives it to you on the back end.  This may sound familiar, as in these respects, they are like Roth IRAs.

Whether you should consider a Roth 401(k) as opposed to a regular 401(k) depends upon the same factors one considers in choosing a traditional IRA versus a Roth IRA: how long the money will stay in the account, how much it will earn and what your tax rates are when you put the money in and take it out.

Employees will be able to contribute to one or both accounts, but they can't switch money from one plan to the other after it goes in.  Nor can they double their contribution by having both types of 401(k) accounts. The same contribution limit will apply to either account, or both combined.

If an employer provides a matching contribution, the match must be put into a regular 401(k) account, even if the employee directs all of his or her contributions into a Roth 401(k).

While the Roth 401(k) was authorized back in the 2001 tax law, it has received little attention because employers can't begin offering them until Jan. 1, 2006. There will be much more publicity in the months to come.

The most you can put in a Roth IRA next year is $4,000 (or $5,000 if you are 50 or older).  The most you can put in a Roth 401(k) next year will be $15,000, which is the same contribution limit that will apply to regular 401(k) plans in 2006.  If you put money in a Roth 401(k) and a regular 401(k), your total allowed contribution to both accounts combined is $15,000.

People 50 and older can contribute an extra $5,000 to their 401(k) plan next year. The proposed regulations do not say whether this catch-up contribution will also be allowed in Roth 401(k) accounts. Some employers may be reluctant to offer them because, like most provisions of the 2001 tax act, they expire after 2010.