Roth 401(k) Plan

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Waseem Alim

A Roth 401(k) is a retirement savings plan which allows an individual to save for retirement and grow his investments without paying taxes on capital gains and dividends. A Roth 401(k) is administered by the employer and combines the function of a 401(k) and a Roth IRA. Unlike a regular 401(k), contributions to a Roth 401(k) are not tax-deductible; however, withdrawals upon retirement are not taxed.

Since the Roth 401(k) is funded by after-tax dollars, individuals can withdraw their contributions to the account without facing any penalty or taxes. However, withdrawals beyond contribution cannot be made till the employee reaches the age of 59½ and has had the account for 5 years (except under special circumstances). Withdrawals (above contribution) before this age are subject to 10% penalty and income taxes. For example: if someone has contributed $25,000 to a Roth 401(k) and had gains of $3,000, he would be allowed to withdraw up to $25,000 without paying a penalty.

Moreover, the owner of these accounts, must to take minimum distributions, i.e. they are required to withdraw, starting at the age of 70½. This is mandatory, unless the account holder continues to work for the employer who sponsored the plan at the age of 70½ or is a 5% owner of the company.

Benefits of a Roth 401(k)

• Individuals can defer up to $15,500 for the year 2008 and $16,500 for 2009. Persons over the age of 50 can contribute an additional $5,000 in 2008 and $5,500 in 2009. Any contribution to a regular 401(k) or 403(b) reduces this limit. For example: if an employee (under 50) puts in $10,000 in a 401(k) plan in a year, he can only put in $5,500 in a Roth 401(k) during that year.

• Employees are immediately 100% vested with their own tax deferred contributions, and if they leave their employer, they can roll their account into a Roth IRA, or to a new Roth 401(k).

• Some plans offer "matching" contributions from their employer, i.e. the employer will contribute an amount proportional to the individuals own contribution. For example a 5% match means that the employer will match contributions up to 5% of the employees annual salary. In other words, if someone earns $50,000, and contributes $4000 to his/her 401(k), the employer will contribute a maximum of $2500 (5% of salary). In some cases, the match is not dollar-for-dollar and employers may only match 50%, or 25% of the employee's own contribution.
  • However, matched contributions are put into a regular 401(k) instead of a Roth 401(k).

• Since the Roth 401(k) is funded by after-tax dollars, individuals can withdraw their contributions to the account without facing any penalty or taxes. However, withdrawals beyond contribution cannot be made till the employee reaches the age of 59½ and has had the account for 5 years (except under special circumstances). Withdrawals (above contribution) before this age are subject to 10% penalty and income taxes. For example: if someone has contributed $25,000 to a Roth 401(k) and had gains of $3,000, he would be allowed to withdraw up to $25,000 without paying a penalty.

• If the employee is in a higher tax bracket during retirement than he is when he is putting money in the Roth 401(k), the plan allows him to pay a lower tax rate than he would in a regular 401 (k) -- since withdrawals during retirement are tax free.

Disadvantages of a Roth 401(k)

• Since money put in the account is after-tax, the employee will have a lower balance to begin with in the Roth 401(k), compared to a regular 401(k). However, some plans allow the contribution percentage to be based off of gross income, and not net income, so the invested amount would be the same with either a traditional 401(k) or a Roth 401(k).

• Investment choices via a Roth 401(k) are limited compared to an IRA. Moreover, most 401k's allow investment changes about once a quarter -- which means that an individual cannot unwind from a position quickly.

• Early withdrawals above the total contribution are subject to a penalty of 10% plus taxes.
  • Exceptions include: the death of the employee, total and permanent disability, separation from service in or after the year the employee reached age 55, a qualified domestic relations order, and deductible medical expenses, exceeding the 7.5% floor.

• Unlike the Roth IRA, Individuals who have a Roth 401(k) must start taking minimum distributions by April 1 of the calendar year after he reaches age 70½. If the owner wants to leave the money for his heirs, the estate planning benefits of the Roth 401(k) falls short of those offered by the Roth IRA.

• Employers have the choice to not offer the Roth 401(k). This may be the case if employers feel that the administrative costs are burdensome. In addition, employers have the option to restrict individuals with less than 1 year of service, union members, non US citizens, part-time workers etc., from being eligible for the plan.

How to start a Roth 401(k) plan

Roth 401(k) plans are offered through an employer. By participating in this plan, an employee authorizes the employer to retain part of their salary for these plans. Most human resources departments will have details on starting such an account with the employer.

When leaving an employer, a employee can choose to leave the Roth 401(k) with his old employer -- in many cases, employers will charge a fee for managing Roth 401(k) plans of ex-employees. An individual can also cash out his Roth 401(k), but this would result in a penalty of 10% on amounts above his contribution. The best option is to rollover a Roth 401(k) to a Roth IRA, or a new Roth 401(k).