Since January 1 2006, employers offering 401k retirement plans to their employees have been able to amend their plans to accept contributions on an after-tax basis, similar to Roth Individual Retirement Accounts (Roth IRAs).
Designated Roth contributions grow with tax-free earnings and are distributed at retirement without triggering any future income tax liability. Although the Roth 401k option was intended to expire on December 31, 2010, the Pension Protection Act of 2006 extended the program indefinitely. Here are some things to consider:
BENEFITS FOR EMPLOYEE-PARTICIPANTS
The Roth 401k combines elements of both a Roth IRA and a traditional 401k plan. The Roth 401k:
- Does not limit participation by income, unlike the Roth IRA
- Allows participants to contribute on an after-tax basis, like the Roth IRA, up to the amounts permitted under a traditional 401k.
Therefore, higher income employees who are ineligible to open a Roth IRA can instead contribute to a Roth 401k at higher amounts than are permitted in a Roth IRA. By contributing to a Roth 401k plan, employees can contribute on an after-tax basis without being taxed in the future.
ROTH 401K REQUIREMENTS
For an employer to offer a valid Roth 401k plan:
- The employer must also offer a traditional 401k plan. Designated Roth accounts cannot exist without an accompanying pre-tax elective deferral plan
- Participants must be able to designate some or all of their elective deferrals as Roth 401k contributions
- The employer must include designated Roth contributions in the employee’s gross income (IRC 402A(a)(1))
- Roth contributions must be tracked and their records kept in a separate account, with any applicable earnings and losses allocated to that Roth account
Employers may not make contributions to a designated Roth account. Any employer contributions, such as matching or profit-sharing contributions, must be treated as pre-tax contributions and added to the participant’s pre-tax account. (However, special rules apply for in-plan rollovers to a Roth accounts)
DISTRIBUTIONS FROM ROTH 401K ACCOUNTS
As with a traditional 401k plan, participants may only receive distributions from their Roth 401k accounts on (if permitted under the plan’s terms):
- Terminating employment
- Reaching age 59 1/2
- Determination of hardship
In addition, unlike the Roth IRA, Roth 401k plans are subject to the IRC’s minimum required distributions requirements during the participant’s lifetime
ADDITIONAL CONSIDERATIONS FOR ROTH 401K PLANS
Employers may choose to offer the following optional features in Roth 401k plans:
- Automatic enrollment
- Employer matching to the accompanying pre-tax account.
- In-plan rollovers
- Plan loans. All of the participant’s Roth and non-Roth accounts are combined when applying plan loan rules
So, who should consider taking advantage of the new Roth in-plan conversion rule? Here are a few of the most compelling examples:
- Young savers: If you are just starting out in your career, you are likely in a lower tax bracket and have a smaller account balance. Converting some or all of your existing pretax account will set you up for more than 40 years of tax-free compounding. Just make sure that the move does not bump you into a higher tax bracket.
- Someone saving for somebody else: Assets in a Roth account are bequeathed income-tax free to a spouse or the next generation. This right allows the recipient to extend the tax-free compounding for many more years.
- Someone with a lot of deductions or a large loss: If you find yourself with a large tax deduction such as a business loss, charitable contributions, or even medical expenses, the taxable income generated by an in-plan Roth conversion is a creative way to fully utilize some or all of these deductions. A sudden drop in your 401k account value (think 2008) might also present a window of opportunity to convert to a Roth, pay taxes on a greatly reduced amount, and then withdraw the resulting rebound tax-free years later.
- Someone concerned about being in a higher tax bracket in retirement: Many American workers today find themselves in a historically low tax bracket. So paying taxes on your retirement savings at today’s low rate hedges the possibility of higher tax rates in the future.
- Action steps: First, while Roth in-plan conversions are part of the new IRS rules for retirement plans, they are not automatically available to everyone. Your employer must amend its plan to allow for them. If you’re interested in taking advantage of a Roth in-plan conversion, step one is to ask your employer if they have taken the necessary steps to make them available.
While it’s critical to spend the requisite time making sure that you’re saving enough and properly invested for retirement, the tax efficiency of your retirement investment strategy deserves some attention as well because it can have a profound impact on your ability to retire comfortably. Hence used properly, a Roth in-plan conversion is a powerful new tool that can help you achieve your goal of financial security in retirement.