Roth 401(k) - The Roth 401(k) Plan

The Roth 401(k) Plan

The Roth 401(k) combines some of the most advantageous aspects of both the 401(k) and the Roth IRA. Under the Roth 401(k), employees can decide to contribute funds on a post-tax elective deferral basis, in addition to, or instead of, pre-tax elective deferrals under their traditional 401(k) plans. An employee's combined elective deferrals-- whether to a traditional 401(k), a Roth 401(k), or to both-- cannot exceed the IRS limits for deferral of the traditional 401(k). Employer's matching funds are not included in the elective deferral cap but are considered for the maximum section 415 limit, which is $50,000 for 2012.

Employers are permitted to make matching contributions on employees' designated Roth contributions. However, employers' contributions cannot receive the Roth tax treatment. The matching contributions made on account of designated Roth contributions must be allocated to a pre-tax account, just as matching contributions are on traditional, pre-tax elective contributions. (Pub 4530)

In general, the difference between a Roth 401(k) and a traditional 401(k) is that the Roth version is funded with after-tax dollars while the traditional 401(k) is funded with pre-tax dollars. After-tax dollars represent money for which taxes are paid in the current year, and pre-tax dollars are those that do not represent federal taxable income in the current year. Typically, the earnings on Roth contributions will be tax free as long as the distribution is made at least 5 years after the first Roth contribution and the attainment of age 59 1/2, unless an exception applies.

A Roth 401(k) plan will probably be most advantageous to those who might otherwise choose a Roth IRA, for example, younger workers who are currently taxed in a lower tax bracket, but expect to be taxed in a higher bracket upon reaching retirement age. Higher-income workers who wish to save the maximum amount allowed may favor the Roth 401(k) because it effectively allows greater real contributions, as post-tax dollars are more valuable than pre-tax dollars; however, those near the Roth IRA income limits may prefer a traditional 401(k), since its pre-tax contributions lowers Modified Adjusted Gross Income (MAGI) and thus increases eligibility for Roth IRA contributions. Another consideration for those currently in higher tax brackets is the future of income tax rates in the U.S. (if income tax rates increase, current taxation would be desirable for a wider group). The Roth 401(k) offers the advantage of tax free distribution, but is not constrained by the same income limitations. For example, in tax year 2012, normal Roth IRA contributions are limited to $5,000 ($6000 if age 50 or order); whereas, up to $17,000 could be contributed to a Roth 401(k) account, provided no other elective deferrals were taken for the tax year (no traditional 401(k) deferrals taken).

Adoption of Roth 401(k) plans has been relatively slow, and stated reasons for this include the fact that they require additional administrative recordkeeping and payroll processing. However some larger firms have now adopted Roth 401(k) plans, and this is expected to spur their adoption by other firms including smaller ones.