The Roth 401(k) – How After-Tax Contributions Work, Comparisons with Roth IRA, Future Tax Rates, Contribution Limits & Frequently Asked Questions

(August 11th, 2009)

In 2006, a new form of a 401(k) plan funded with after-tax contributions was created, and was named based on the Roth IRA and the traditional 401(k) to come up with a similar but new name, the “Roth 401k.” The Roth 401k was created by the provisions stated in the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRA). Particularly modeled after the Roth IRA, the Roth 401(k) does NOT allow investors to deduct their contributions to this plan from their income tax returns, and receive a break or a deduction from their taxes. This thus creates more tax revenue for the IRS in the short term, and that is one of the main reasons why the Roth 401(k) is favoured by the taxation authorities. Since you pay taxes now, the advantage of contributing to a Roth 401(k) is that upon retirement, you can withdraw your money tax-free provided you are at least 59 and ½ years of age or older and have had a Roth 401(k) account for more than 5 years.

Comparisons with Roth IRA

The Roth 401k provides a greater advantage to highly compensated employees who cannot contribute to a Roth IRA due to the income phase-out ranges and salary limits imposed on Roth IRAs. Eligibility for 2009 income phase-out ranges is between $105,000 and $120,000 for single filers and $166,000 to $176,000 for those who are married and file jointly. Roth 401(k), unlike the Roth IRA does not have income phase-out ranges. The Roth 401(k) is also subject to contribution limits of regular 401k plans - $16,500 for 2009 or $22,000 for those 50 or older by end of the year unlike the Roth IRA where the contribution limit is $5000 for 2009 and $6,000 for people 50 years or older by end of the year. This allows investors contributing to a Roth 401(k) to stack away thousands of more dollars than they would be able to if they contributed to a Roth IRA.

Note: These contribution limits apply to both types of 401(k) plans; therefore you cannot put $16,500 in a regular 401k and another $16,500 in a Roth 401(k).

Future Tax Rates

Also contributing to a Roth 401k comes as a dilemma for many investors because they will be forced to pay the tax upfront now before they can contribute to a Roth 401k thus taking home less pay every month. Or, these investors have the choice of contributing to a traditional 401k and hope that during retirement, they will be in a lower tax bracket thus will pay lower taxes upon retirement.

If you expect your tax rate to be higher during retirement, it is better to go with a Roth 401(k) now and get done with taxes now. This is likely to be the case with young employees who expect their incomes to be higher when they retire as they obtain more experience and take on more seniority. For those people who are already in the 15% - 35% tax brackets, it is a better idea to be done paying the taxes now, and not worry about the tax rates in the future, as since their incomes are likely to increase in the future, they might have to pay slightly higher taxes later. However, if you are currently in your peak earning years and expect your income to be lower during retirement, than it is better to stick to a traditional 401(k) because you will pay taxes on these contributions when you retire (that is in the case of traditional 401(k)s.

Predicting tax rates in to the future is not an easy matter because no one can predict with certainty what the tax rates will be in the coming years. However, the general understanding is that future tax rates will be higher to help the government offset the current budget deficits in the economy as well as to finance all the stimulus packages that President Obama is giving out. Future increases in taxes will also help the government pay for Social Security benefits and Medicare. This is why people in the top tax brackets have indicated a higher interest in a Roth 401(k).

FAQs on Roth 401(k)s

i) Who is Eligible for Participating in a Roth 401k?

Anyone whose employer offers a Roth 401(k) plan is eligible for participating in it, although the employer have its own set of vesting & eligibility rules – it is best advised to check with your company’s 401(k) plan administrator. One of the major costs associated with offering Roth 401(k) plans for their employees is the costs associated with implementing/managing the plan and educating their employees about investment options in it.

ii) What about Employer Matching on Roth 401(k) Contributions?

Employer matches are made using pre-tax dollars, and the match accumulates in a separate account that is taxed as ordinary income at withdrawal.

iii) What happens if I quit or leave my job?

The balance in your Roth 401(k) can be rolled over to a Roth IRA.

iv) Is the Roth 401(k) a long term deal, or will it erode away in the coming years?

No the Roth 401(k) is here to stay because it was made permanent thanks to the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRA).

v) How about early Withdrawal rules?

Early Roth 401(k) withdrawals are subject to similar rules as traditional 401(k)s.