Watch for more Roth 401(k)s, thanks to new legislation

by Center for Personal Finance editors

NEW YORK (8/28/06)--New pension legislation is expected to prompt more companies to offer retirement-savings plans known as Roth 401(k)s, which give savers a tax-favored incentive to sock away funds into an account that combines traditional 401(k) features with those of the Roth IRA (The Wall Street Journal Aug. 16).

The new law makes Roth 401(k) plans permanent. Previously, the plans were allowed to expire after 2010, and many employers were leery about offering them. A survey earlier this year by Deloitte Consulting LLP in Washington revealed that only 12% of employers had plans to offer Roth 401(k)s this year. Analysts now expect that number to jump.

Get a handle on the basics:
How is a Roth 401(k) different from a regular 401(k)?

You make contributions to a traditional 401(k) with before-tax dollars, and you get an upfront tax deduction. On the other hand, you make contributions to a Roth 401(k)�like the Roth IRA�with after-tax dollars, so you won't get an upfront tax deduction but the account grows tax-free and your withdrawals aren't subject to income tax.

What are the withdrawal rules?

You must hold the Roth 401(k) for at least five years before you get tax-free withdrawals. Before that, you'll pay a 10% penalty. Money can be paid out when you terminate employment or when you reach 59 1/2 (Businessweek.com).

Does the employer match contributions to a Roth 401(k)?

Yes, but those matches are with pretax dollars, and the match accumulates in a separate account taxed as ordinary income at withdrawal. This adds more paperwork for the employer, which is why some companies may balk at offering the plan.

How much can go into the account each year?

Contribution limits won't change--those younger than 50 can contribute $15,000 total in 2006. That means you can't save $15,000 in a regular 401(k) and another $15,000 in a Roth 401(k). If you're 50 or older, you can save an additional $5,000 in the Roth 401(k) because of catch-up provisions. Remember: Roth IRA contributions are limited to $4,000 a year for 2006, or $5,000 for those 50 or older.

What are the income limits on who can contribute?

There aren't any. That makes the Roth 401(k) a potential boon for upper-income individuals who bump up against eligibility limits for contributing to a Roth IRA; eligibility phases out between $95,000 and $110,000 for single filers and between $150,000 to $160,000 for those who are married and file jointly.

Who should consider a Roth 401(k)?

If you expect your tax rate to be the same or higher in retirement than it is now, the Roth 401(k) may be a good savings option. Similarly, young people just starting their careers who expect their incomes to increase in the future may want to sign up. If you're in the 15% or 25% tax bracket, you may want to bite the bullet and pay those taxes now so you won't have to worry about what your tax bracket will be in the future. However, if you're in your peak earning years and you think your tax bracket will be lower in retirement, you might be better off sticking with the traditional 401(k) contributions (SmartMoney.com).

For more information, read "Introducing the Roth 401(k)--A New Workplace Savings Opportunity" in the Home & Family Finance Resource Center money savvy section.