Roth 401k: What Is It?

Posted by Madison

money-nest-eggIn Roth IRA Conversion Rules Highlighted Russ commented that his employer is starting a Roth 401k plan in 2008. The Roth 401k plans are relatively new and many people haven’t heard of them yet. Employers are slowly starting to offer them to employees. Let’s explore how the Roth 401k works, the benefits over the Roth IRA, and why it is taking time for employers to offer them!

What is a Roth 401k?

The Roth 401k is a great retirement savings vehicle with many of the same benefits as a Roth IRA including:

  • Tax free growth.
  • Ideal for investors currently in a low tax bracket, but anticipate being in a higher tax bracket in retirement. This is the case for many younger workers.
  • Offers the ability to diversify accounts against tax treatment using a combination of regular 401k and Roth 401k. A great idea because of the uncertainty of taxes in the future.

In addition, for those who are interested but restricted from participating in a Roth IRA, the Roth 401k makes sense. Additional benefits over the IRA include:

As always, there are other points to consider including the investment options and expenses of the investments when deciding whether or not to participate in a Roth 401k.

Why Employers are Slow to Implement

The Roth 401k didn’t have a lot of employers that immediately put it into place because the original legislation made it only a temporary plan existing from 2006-2010. That changed in 2006 when the Pension Protection Act was signed making the Roth 401k permanent. Employers may still be reluctant because they have to account for the following:

  • Keeping the highly paid employees contributions in line with the others to keep the plan qualified.
  • Additional education needed to help employees make the right choice between the traditional pre-tax option and the new after-tax option.
  • And of course the plan sponsor would charge additional fees.

Other Roth 401k Tidbits

  • Employer matching funds will still be deposited into the pre-tax 401k account.
  • Further advantages for proprietors of owner-only businesses are detailed in an old article from Investment Advisor.

Action Plan

I will keep encouraging my employer to offer the Roth 401k. It will benefit a great deal of the workforce. Until I get the plan offered to me, I’ll continue to get excited for readers, like Russ, who get to take advantage of it. It would be great to hear from others that are getting the chance to participate. And don’t forget, if you have both, you can contibute to a Roth 401k and a Roth IRA at the same time.

Update!

My employer decided to offer a plan for 2008! Read about it, including some reader questions about the Roth 401k.



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Comments to Roth 401k: What Is It?

  1. My employer is offering a Roth 401(k) next year as well. I spent some time evaluating the pros and cons (see link below). The tax diverisification of the Roth 401(k) is appealing, but its tough to give up the huge tax deduction of $15,500 afforded by the regular 401(k).

    http://thefinancialengineer.bl.....tible.html

    kris

  2. For the average person, I would not recommend using a Roth 401k for the following reasons:

    1) Your taxable income becomes higher. For example, if you contributed 15% to a regular 401k, your taxable income would be 17.6% lower than with a Roth 401k. If you made $99,000 in income and were single in 2006, your federal tax would have been $21,824, a 22% tax rate if you contributed to a Roth 401k. With a regular 401k and a 15% contribution, your taxable income would have been $84,150 and your tax $17,680 (a 21% tax rate). That is a 23.4% difference in tax liability off of the same paycheck.
    2) You are putting less money to work for retirement.
    3) Your employer match does not help you lower your cost basis for individual funds in a Roth 401k because they are not invested in the Roth.
    4) If you do contribute to a Roth 401k and have a company match, you will have to track multiple accounts.
    5) With a Roth IRA, one benefits from having higher yielding securities because dividends and capital gains are not taxed. Ever. In a company’s Roth 401k plan, one is not as likely to have higher yielding securities available in a way that allows them to remain diversified and benefit from a greater tax free yield.

    These are just some of the reasons I would not use a Roth 401k. I prefer to use the regular 401k and then manage a Roth IRA in a brokerage account where I have access to all securities available. My Roth IRA is diversified with fifteen stocks, funds and ETF’s and yields 5.2%. The account has a CAGR of 12% over the past five years.

    Cavemanus

  3. @ Kris: Lucky you! You are right, it’s a lot of taxes to swallow up front. Great pros and cons.

    @Cavemanus: Let me address each point separately;)

    1) Agreed, your taxable income is higher. However, if it is lower than you anticipate it being in retirement, you will come out ahead. Unfortunately nobody knows which way taxes will go, but I’d be willing to bet we won’t be seeing 15% tax brackets in the future.
    2) The deferral limits for both the traditional and Roth 401k are the same, so you aren’t limited to contributing less money. Mathematically, assuming tax rates are the same now and in the future, both ways give you the same amount in retirement*. Like above, it all depends which way tax rates will go.
    3) I’m not sure where you are going with this one. Because the Roth 401k (and IRA) are tax free, basis doesn’t matter, since the gains are not taxed. Is there a reason you are focused on lowering the basis?
    4) Great point! It does add another element of paperwork. I’m hoping the plan administrators will find an efficient way to do this for employees that isn’t too complicated.
    5) Agreed. The limited choices that many plans offer won’t allow people to use them as efficiently as a Roth IRA.

    All very good points for readers to think about. I’m still crossing my fingers to get access to one because I believe taxes will be going up, I don’t mind tracking another account and we have access to some funds that will work will with my asset allocation strategy. It will vary for each person and their circumstances.

    *I don’t completely agree with the math that equates using either the traditional or Roth, but more about that in another post!

    Madison

  4. I don’t know much about these retirement plan options. I hope you can help me out and let me know if I should be doing something differently. I earn a high income of around $500,000 per year. I don’t put money into any type of IRA (Roth or Traditional) because of the income limits. I contribute fully to my company 401k right in the beginning of the year, so I get the company match earlier. We have a traditional 401k. I work for a small firm where virtually everyone (I think even our receptionist) earns more than the IRA income limits. Would it make sense for us to go this Roth 401k route? If so I’d like to send a note on it to the guy who manages these things for us. I feel like an idiot asking this question but I don’t know much about the rules and regulations around retirement plan options. I work in finance, but very different sort of thing (wall street).

    JD

  5. @JD:
    Great question. I can’t answer completely because I don’t know all the details about your company (number of employees, compensation, etc.). However, I do feel that the Roth 401k is a great plan for many companies to offer for their employees as some people may want to participate in it. It would be a good plan to offer in addition to a traditional 401k, as some employees will want to remain with it for the pre-tax contributions.

    Here’s some considerations for your company:
    -Cost to administer additional plan.
    -Interest in plan. Taking an informal poll before setting it up would be a great idea.
    -Meeting the regulations (keeping the plans qualified, monitoring highly compensated employees, etc).

    Hopefully that helps you get going in the right direction.

    Madison

  6. My company offers both Traditional 401(k) and Roth 401(k) plan(s). I know that the total contribution limit (for 2008) for any combination of both plans is $15,500 ($20,500 if over age 50). What I’d like to know is: Can I “max out” on the combined limit at my company and still make a separate Roth IRA contribution (up to $5,000 / $6,000 if over 50) apart from my employer as long as my modified AGI is under the limit ?

    Gary

  7. @ Gary: Yes, we have been maxing out both the company plan (traditional or roth 401k) and our Roth IRAs for many years without a problem.

    The rules for the company plan are limited by any highly compensated employee rules (your company will let you know if you are affected) and the rules for the Roth are based on the MAGI (like you specified above).

    As long as you follow the rules for each one, you should be fine to use both!

    Madison

  8. Praise the lord for pension plans. Don’t know what I would do without them!!

    German Aunkst


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