Introducing the Roth 401(k)--A New Workplace Savings Opportunity

While the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) is old news, it introduces an exciting new opportunity for some retirement savers starting in 2006. The new Roth 401(k) is almost a hybrid of the 401(k) and the Roth IRA (individual retirement account). This means there's another way to save for retirement at work--and get tax-free income when you retire.

Before you sharpen your pencil to calculate your tax-free savings, you'll want to learn more about the advantages and disadvantages of the Roth 401(k). First--and most important--not all employers plan to offer it to employees immediately. In fact, according to a survey conducted in early 2005 by Hewitt Associates, Lincolnshire, Ill., a global human resources consulting firm, only about one of three employers said they were planning to add the Roth 401(k) to their benefit offerings for 2006.

"Chances are more employers will get on board as employees become aware of this valuable savings tool and ask for it at work," says Dennis Zuehlke, compliance manager, IRA Services at CUNA Mutual Group, Madison, Wis. Many companies have hesitated due to the competition associated with the offering. "Most employers adding the new Roth 401(k) to their benefit choices will also continue to offer their traditional plan options," adds Zuehlke.

If you're among the early Roth 401(k) pioneers, or may have the opportunity to jump in somewhere down the road, keep these details in mind:

Tax-free vs. tax-deferred withdrawals

Like the Roth IRA, Roth 401(k) contributions are made with after-tax money. The account grows tax-free and the withdrawals of earnings taken in retirement aren't subject to income tax if you're at least 59� years old and have held the account for at least five years.

Contributions to a traditional 401(k) are made with before-tax money or are employer contributions. That means your contributions reduce your taxable income and the amount of taxes you pay now. While that feature is a big advantage today, the money you withdraw from your account in retirement will be subject to taxes at your tax rate at that time.

You can see why tax-free withdrawals are attractive if you expect to be in a higher tax bracket when you retire. If that's not the case, it still might make sense to defer taxes until the day when your income is lower. "The uncertainty of future tax rates adds a question mark to the equation. By paying taxes on your retirement savings up front, there won't be any surprises with higher taxes when you need to withdraw your money," notes Zuehlke.

Contribution limits

Roth 401(k) accounts are subject to the same limits as regular 401(k)s--$15,500 for 2007, or $20,500 for those workers age 50 and older. If you've been stashing cash for a tax-free retirement in a Roth IRA, these limits--and the fact that there are no income restrictions--could be a boon for you. With a 2007 contribution limit of only $4,000 for the Roth IRA ($5,000 for people age 50 and older), it would take several years to equal one year's Roth 401(k) contribution.

If you're not ready to switch all your 401(k) contributions over to a Roth 401(k), note that you can split your dollars and fund both vehicles. "The total amount you can contribute for 2007 is still $15,500 (or $20,500), but you can divide it between both types of 401(k) accounts," Zuehlke says. However, if your employer offers matching contributions, they must be made to the employer's matching contribution account, not to the Roth 401(k) account. "If your employer offers a match, be sure you contribute enough to your 401(k) to take full advantage of the matching dollars. If you don't, it's like giving up free money," Zuehlke says.

The sunset provision

Required minimum distributions (RMDs)

Paving the way for a comfortable retirement

Whether your retirement savings choice is the new Roth 401(k) or traditional 401(k) or an IRA, one thing is certain: It's best to save early and consistently. Zuehlke recommends making your retirement plan contributions through payroll deduction or another type of automatic savings plan. "You won't miss the money once your contributions are routine. It's so much easier than having to write a check for your annual contribution all at once," he adds.

Ideally Zuehlke suggests maxing out your 401(k) contribution and then funding a Roth or traditional IRA as well. In a perfect world, investors would take advantage of all the tax-free and tax-deferred opportunities for retirement savings, but assess your personal situation and save in the way that makes most sense for you.

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Published March 1, 2006, Reviewed July 30, 2007