What's a Roth 401(k)?

If you know anything about retirement plans, you probably know about the big guys: the 401(k), the traditional IRA, and the Roth IRA. But what about the Roth 401(k)?

Quick review of the more well-known plans: A 401(k) is a tax-deferred retirement plan offered by your employer, meaning money is deducted from your paycheck before taxes, but you pay taxes when you withdraw the money in retirement. An IRA is a retirement account you set up yourself: A traditional IRA offers an up-front tax break by letting you deduct your contribution from your income for that year, while with a Roth IRA you pay taxes before you contribute, but then you'll never be taxed again.

The Roth 401(k)—a combo of the Roth IRA and 401(k)—is the new kid in town. It began in 2006, and only a third of employers offer it, as of the last count. But it could grow in popularity now thanks to a provision in the new Small Business Jobs Act (SBJA) that will soon make it easier for some 401(k) holders to switch to a Roth 401(k).

Why would you want to switch? In a sense, the Roth 401(k) is the best of both worlds: the tax advantages of a Roth IRA and the company support (and, often, matching program) of a 401(k). The amount you can contribute is the same as a 401(k): up to $16,500/year for most participants, with an extra $5,500 for workers 50 and older. However, while money in a regular 401(k) is deducted pre-tax, Roth 401(k) funds are deducted from your after-tax income.

Here's the catch (you knew there'd be one!): If you switch from a pre-tax 401(k) to an after-tax Roth 401(k), you have to pay taxes on the funds you're converting. (Just like when you switch from a traditional IRA to a Roth IRA.) This tax payout may turn off older workers who have a considerable amount built up in their account and can more easily afford to pay taxes in smaller increments, as they withdraw funds post-retirement, than in one huge lump. Generally, paying taxes now through the Roth option is good for workers who expect to end up in a higher tax bracket by retirement, or who are concerned that tax rates will rise in the future.

With the Roth 401(k) provision coming on the heels of the IRS lifting the income limit for folks to roll over a traditional IRA into a Roth IRA, this has been a banner year for expanding retirement account options. However, many of the details of the roll over option are still in flux. Since the SBJA was just passed in late September, employers and the IRS are scrambling to figure out how this provision will actually work in practice, and most employers face a deadline of December 31 to make changes to their 2010 plan offerings. According to a lawyer I spoke with who has written about the new provision, many observers expect the IRS to offer additional guidelines within the next month or so. If you're interested in rolling over to a Roth 401(k), ask a human resources representative about your company's plans.

Would you switch to a Roth 401(k)?

 

Comments

[RJ Weiss]

Beth...Do you have to convert your entire portfolio over to a Roth? If I'm not mistaken, I thought it's possible to own both a Traditional and Roth 401(k) at the same time.

[Beth]

You're absolutely right, RJ, you can certainly own both. And, depending on the rules that the IRS and your company sets, there may be restrictions on how much money you can transfer to a Roth 401(k). More details here: http://www.kiplinger.com/magazine/archives/a-new-way-to-move-into-a-roth-401k.html and I'll be sure to post an update once the IRS has more info (hopefully by end of year).

[RJ Weiss]

Thanks Beth for responding. For those who want to hedge their tax strategy, owning both a Traditional and a Roth is a smart move.