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THE ROTH 401(k)
Texas Society of Certified Public Accountants
Many employers offer their employees a Roth 401(k), which combines the tax-free withdrawal
aspect of a Roth and the higher contribution level of a 401(k). More than 14 million American
households have opened Roth IRAs since they were first offered in 1998. Tax-free and no
mandatory withdrawals helped feed interest in these retirement savings accounts.
How the Roth 401(k) Works
Eligibility: Employees who are eligible for their employer’s 401(k) plan also would be eligible for
a Roth 401(k). Unlike a Roth IRA, there isn’t an income limitation. However, the amount highly
compensated employees can contribute to a Roth 401(k) may be limited if their employer places
a similar limit on traditional 401(k) contributions.
Contributions: Contributions are made with after-tax dollars, whereas contributions to a
traditional 401(k) are made with pre-tax dollars. The maximum amount an employee can
contribute to a Roth 401(k) is the same as for a traditional 401(k): $17,000 in 2012. Employees
50 and older can make an additional $5,500 catch-up contribution; for a grand total of $22,500.
Contributions can be split between the two types of accounts, and funds will be held separately.
However, the contribution limit is for both accounts combined, not individually.
Matching Contributions: Employers are not required to make any contribution to a Roth
401(k). If your employer does provide matching contributions, those funds will be subject to
taxes upon withdrawal in retirement.
Withdrawals: The benefit of the Roth 401(k) is that withdrawals are tax-free after age 59½ if the
account has been open at least five years. If you leave the company before age 55, withdrawals
of earnings would be taxed and generally hit with a 10 percent penalty, unless they’re rolled
over into a Roth IRA.
Under current tax law, Roth distributions do not count as income and therefore don't contribute
to making Social Security benefits taxable in retirement. Traditional 401 (k) withdrawals are not
only taxable but can raise income levels and make Social Security benefits taxable.
Traditional 401(k) accountholders are required to take mandatory minimum withdrawals starting
at age 70½. Furthermore, Roth 401(k) payouts are tax-free while payouts from traditional
401(k)s are taxed.
Pros and Cons
Mid-Career Workers: The promise of tax-free withdrawals in retirement would be appealing to
mid-career workers who anticipate tax rates will rise in the future and want to shield their
retirement income from Uncle Sam.
High-Income Individuals: Workers who earn too much to contribute to a Roth IRA but want
tax-free retirement income would benefit from the Roth 401(k), which doesn’t have income
limitations. Even with Roth deferral matches are still received, but they are pre-tax match funds
just like profit sharing allocations.
Additionally, because Roth accounts are tax free, $1,000 in a Roth is equivalent to saving more
than a $1,000 in a traditional IRA. Thus, maximizing Roth 401 (k) contributions is like saving
more money than you could with an equivalent amount in a Traditional 401 (k).
Who Should Think Twice?
Near Retirement Workers: Who will be retiring soon and will be in a lower tax bracket probably
won’t benefit from the Roth 401(k)’s tax-free withdrawals. They would be better off sticking with
the traditional 401(k), so they could lower their taxable income while still in a higher tax bracket.
Unsure about Future Tax Bracket: Individuals who don’t know whether they will fall into a
lower tax bracket in retirement might want to stick with their traditional 401(k) plan or split their
contributions in case they actually stay in a higher tax bracket.
Additional personal finance information is available online from the Texas Society of Certified
Public Accountants at www.ValueYourMoney.org.