The Roth 401(k) plan -- a combination of popular 401(k) accounts for employees and the Roth IRA concept for individuals -- has been relatively slow to catch on in the workplace. But the federal government recently announced that it is offering this hybrid retirement savings option to its 3.3 million U.S. government workers.*

If it's good enough for Uncle Sam, does the setup make sense for your business operation? It may be time to

Differences and Similarities

Roth 401(k)

401(k) Plan

Roth
IRA

Contributions made with

After-tax dollars

Pre-tax dollars

After-tax dollars

Withdrawals

If qualified, free from federal and possibly state tax

Taxed

If qualified, free from federal and possibly state tax

<>Contribution limits in 2012

Up to $17,000 ($22,500 for those age 50 or older at year-end)

Up to $17,000 ($22,500 for those age 50 or older at year-end)

Up to $5,000 ($6,000 for those age 50 or older at year-end)

Withdrawal requirements under the minimum distribution rules

Must start taking at age 70 1/2

Generally must start taking at age 70 1/2

None -- can leave account untouched and pass on to heirs.

Income
limits

None to participate

None to participate

Cannot contribute if income is above certain limits (2012 phaseout begins at $173,000 AGI for married filing jointly and $110,000 for single and household head.

take a closer look.

A recent survey indicates that 39 percent of employers with retirement plans offer a Roth 401(k) option, with 29 percent more likely to add it this year. Approximately 6 percent of the eligible workers are taking advantage of this feature.

Surprisingly, the Roth 401(k) has been around for awhile. It was initially authorized by the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), but didn't officially become available until 2006. Under EGTRRA, this provision was scheduled to expire after 2010, but it was made permanent and enhanced by subsequent legislation. The IRS has also issued regulations governing its use. Most of the usual nondiscrimination requirements for regular 401(k) plans also apply to Roth 401(k)s.

The plan works pretty much like the name implies. As with a regular 401(k) plan, an eligible employee can elect to defer part of his or her salary to a separate account, subject to the generous annual limits in the law. The company may also provide matching contributions based on a percentage of salary.

For 2012, a participating employee can contribute up to $17,000 in elective deferrals, increased to $22,500 for someone age 50 or over. In comparison, contributions to a Roth IRA established outside the workplace are limited to $5,000 in 2012; $6,000 for those age 50 or over. Also, the ability to contribute to a Roth IRA is phased out for high-income taxpayers.

For 2012, the phase-out begins at $110,000 of modified adjusted gross income (MAGI); $173,000 of MAGI for joint filers.

But here's where the Roth 401(k) takes a marked departure from regular 401(k)s. The contributions to the employee's account are made with after-tax dollars rather than pre-tax dollars. Thus, an employee loses a key current tax benefit of 401(k)s.

On the plus side, when an employee withdraws funds from the account, "qualified distributions" are completely exempt from income tax, just like qualified distributions from a Roth IRA. In contrast, regular 401(k) distributions are taxed at ordinary income rates, which are scheduled to increase in 2013. The top tax rate on ordinary income in 2012 is 35 percent, slated to go up to 39.6 percent next year.

For this purpose, "qualified distributions" include distributions that are:

  • Made after the participant has reached age 59 1/2;
  • Paid on account of death or disability; or
  • Used to pay for "first-time homebuyer expenses" (up to a lifetime limit of $10,000).

In other words, there's a trade-off. A participant in a Roth 401(k) gives up the ability to contribute to the account on a pre-tax basis in return for the lure of receiving tax-free payments in the future. For many workers, it's a good deal, especially if you are restricted from making Roth IRA contributions due to the annual income limits.

Of course, every situation is different. An employee must consider all the relevant factors, including his or her current and anticipated tax rates in retirement and the desire for current tax breaks. Switching from a traditional 401(k) plan to a Roth 401(k) means a cut in take-home pay.

Finally, under a tax law change, 401(k) participants can roll over pre-tax balances to a Roth account, effective as of September 27, 2010. This generally consists of the balance in a 401(k) account with elective deferrals, matching contributions and earnings. The rollover is taxable except to the extent it represents any after-tax contributions.

Is the Roth 401(k) option a good fit for you and your company? Consult with your tax and employee benefits advisers for more information.


 *The "Roth TSP" (Thrift Savings Plan) is the equivalent of a Roth 401(k) for private sector employees, and is now available to federal civilian employees and members of the uniformed services.

 

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