(Article from Fall 2006 Profit Zone)

It is less than a year old, but it is gaining in popularity. Employers who offer 401(k) plans may now offer a Roth version of their plans to employees.

The new Roth 401(k) plans seem to be popular among younger employees who are drawn to the idea of contributing to the plans with post-tax dollars now and taking tax free distributions later. According to a study by Hewitt Associates, a human resources consulting firm in Lincolnshire, Illinois, companies that offer the Roth versions have growing participation rates.

Congress approved the Roth 401(k) in 2001, but it was only made available as of January 1, 2006. It allows employees to save for retirement as they work like a traditional defined contribution plan, but on a post-tax earnings basis. It also appears that more employers are offering the Roth 401(k) option as they realize that the administrative costs are relatively minor. To add the Roth 401(k), employers must amend their plan, provide new enrollment forms and adjust their payroll system to handle this new type of contribution. They must also adjust their record keeping system to track these contributions.

Employees who already have a traditional 401(k) plan may participate in a Roth 401(k) if their employer offers it. If an employer provides a matching contribution to a Roth 401(k), two accounts are set up for each participant. The first contains the employee’s after-tax contributions and any investment growth that will be distributed tax free. The second account contains the employer’s before-tax contributions and any investment growth; these funds are taxable when distributed. However, the combined total contributions cannot exceed the Internal Revenue Service limit set for individual plans, that is, $15,000 (or $20,000 for employees aged 50 or over) in 2006. Participants may elect to completely change their election to a Roth 401(k), or they may opt for a partial change from their traditional 401(k). In other words, an employee who participates in both plans can designate the amount to be applied to each plan. Once a decision is made, the participant cannot switch money among the plans. Roth 401(k) participants who change employers can roll over the proceeds into a Roth IRA.

While a Roth 401(k) is similar in nature to a Roth IRA, there are some differences. There are no income limitations to participate in a 401(k) plan. A Roth IRA has adjusted gross income limits of $160,000 for married couples and $110,000 for singles. The contribution is limited to $4,000 in 2006 ($5,000 for people 50 and over). There is no required distribution date for Roth IRAs. Distributions must begin no later than 70-1/2 for Roth and Traditional 401 (k) participants.

If a Roth 401(k) plan is offered, employees who are considering selection of this plan will need to decide if they think their tax rate is higher at the time contributions are made or at the time of distribution. Historically employees have been encouraged to save pre-tax with the expectation they will be in a lower tax bracket when they retire. Concern about future tax increases will cause many to reconsider this bit of provincial wisdom.

A younger employee who expects to be in a higher tax bracket in the future may be attracted to a Roth 401(k). For example, a $5,000 investment will grow to $66,000 in 30 years assuming a nine percent investment return. That employee would be able to withdraw the entire $66,000 tax free. The Roth contributions could also benefit an older worker who is contributing the maximum amount of $20,000. Contributing $20,000 during 2006 as Roth contributions will result in a larger benefit, net of taxes, during retirement for the participant because the tax liability has already been satisfied.

It should be noted that Roth 401(k) was made permanent in August 2006 with the passage of the Pension Protection Act of 2006.