Pentegra :: The Roth 401(k) -- Is it Right For You?

THE ROTH 401(K): IS IT RIGHT FOR YOU?

THE ROTH 401(K): IS IT RIGHT FOR YOU?

The Roth 401(k): Is it Right For You?

WHAT IS A ROTH 401(k)?

A Roth 401(k) option combines the features of a traditional 401(k) with a Roth IRA, providing employees with a potential source of tax-free retirement income. The key differences between a traditional 401(k) contribution and a Roth 401(k) contribution center on the tax status of both contributions and withdrawals, along with the rules governing rollovers.  Unlike a traditional 401(k) contribution, Roth 401(k) contributions are made on an after-tax basis. Traditional 401(k) contributions reduce a participant's income for federal and (usually) state tax purposes at the time contributions are made and grow on a tax-deferred basis until the participant takes a distribution, which is treated as ordinary income. Roth 401(k) contributions and investment earnings, on the other hand, are tax free upon withdrawal as long as the employee has maintained the Roth 401(k) account for at least five years and has attained age 59 ½.

Aside from these differences, Roth 401(k) contributions are treated the same as traditional 401(k) contributions-normal limits and non-discrimination rules apply. Roth 401(k) contributions are also subject to the same limitations as regular deferrals. Please note, however, that a Roth 401(k) option does not increase the amount of contributions that can be made to a 401(k) plan.  In other words, the current 401(k) plan limits will apply to the traditional 401(k) contributions and Roth 401(k) contributions in the aggregate, including catch-up contributions, if permitted by the Plan. 

Roth 401(k) contributions must be irrevocably designated as such by the participant at the time the deferral is made. Participants can elect both Roth 401(k) and traditional 401(k) contributions in the same plan year. There is no limit as to how deferrals can be split between Roth 401(k) contributions and traditional 401(k) contributions. For example, if a participant elects to defer $100 from each paycheck, he could specify that $50 be designated as a traditional 401(k) contribution and $50 as a Roth 401(k) contribution. Roth 401(k) contributions and earnings are maintained as a separate account within the plan and assets cannot be transferred between the two types of accounts (i.e., Roth 401(k) and traditional 401(k)). Roth 401(k) contributions are also subject to the same withdrawal restrictions, i.e., death, disability, retirement, hardship, etc. Also, please note that any forfeiture under the plan may not be allocated to any participant's Roth 401(k) account. The other key difference between a Roth 401(k) contribution and a traditional 401(k) contribution is that employees can make a direct rollover from a Roth 401(k) account to a Roth IRA. Under a traditional 401(k) plan, funds are typically rolled over to a rollover IRA. And while an employee can convert a traditional IRA to a Roth IRA, income taxes must be paid on the amount that was formerly tax deferred.

WHAT ARE THE TAX BENEFITS OF THE ROTH 401(k)?

The Roth 401(k) may offer advantages to those who are currently in a low tax bracket but who expect to be in a higher tax bracket after retiring.  Another benefit: the Roth 401(k)'s tax-free withdrawals can help highly paid workers manage their tax situation in retirement. For most people, the main reason to contribute to a Roth 401(k) is to let the money grow tax-free. No one knows what the tax rates will be in the future, so it may be beneficial to hedge the taxable contributions and earnings in a traditional 401(k) with earnings in a Roth 401(k) that can be withdrawn tax-free. This may be especially true if you are young and in a low tax bracket but have every reason to believe your income will be increasing, putting you in a higher tax bracket.

HOW DOES THE ROTH 401(k) WORK? 

A participant may contribute up to $16,500 in 2011 (as indexed annually) to a Roth 401(k) and/or traditional 401(k) account, plus an additional $5,500 in catch-up contributions (as indexed annually) if permitted by the Plan and if the participant is age 50 or older.  As stated above, participants can make both Roth 401(k) contributions and traditional 401(k) contributions, subject to the maximum contribution allowable under 401(k) rules, but contributions to a Roth 401(k) account are irrevocable, meaning that once a participant designates a contribution as a Roth 401(k) contribution, those assets may not be re-directed as traditional 401(k) contributions. 

If the Plan provides for employer matching contributions, such matching contributions must be allocated on Roth 401(k) contributions.  Any employer matching contributions funded in association with Roth 401(k) contributions will be accounted for in the same account as matching contributions funded in association with traditional 401(k) contributions.  However, Roth 401(k) contributions and traditional 401(k) contributions must be accounted for in separate plan accounts because of the unique tax treatment of each contribution type.  Participant statements will reflect the separate accounts.

Withdrawals from the Roth 401(k) account can be made tax-free and penalty free provided that the participant is at least age 59 ½ and has held the account for five years or longer, provided your plan permits in-service withdrawals. These are the same rules that apply to Roth IRAs. The same tax penalties that apply to early distributions (prior to age 59 ½) from traditional 401(k) accounts apply to Roth 401(k) accounts. As is the case with a traditional 401(k) contribution, participants must begin taking minimum distributions from a Roth 401(k) account in accordance with minimum distribution regulations (for individuals who are not deemed to be 5% owners, generally this means a participant must begin receiving distributions from a Roth 401(k) account as of the April 1st of the calendar year following the later of the (i) calendar year in which you attain age 70 ½, or (ii) the calendar year in which you retire. This is different than the Roth IRA, which has no distribution requirements.

Roth 401(k) account assets can be rolled over to a Roth IRA when participants retire or change jobs. By contrast, assets in a traditional 401(k) account may only be rolled into a traditional IRA (although a traditional IRA can subsequently be converted to a Roth IRA if desired). In addition, Roth 401(k) plan assets can be rolled into another employer's Roth 401(k) plan, if available, and plan rules allow.

WHAT SHOULD BE CONSIDERED BEFORE ADOPTING A ROTH 401(k) FEATURE INTO AN EXISTING PLAN?

Another pitfall: In the event of an ADP test failure where refunds are required to be paid out of a Roth 401(k) account, employees will be forced to pay taxes on earnings associated with the refunded Roth 401(k) contributions, regardless of whether or not the participant meets the requirements for a qualified distribution.

IS IT BETTER TO CONTRIBUTE TO A TRADITIONAL 401(k) OR A ROTH 401(k)?

Whether the Roth 401(k) feature is the more advantageous savings vehicle depends entirely on the participant's personal situation.  For example, because Roth 401(k) plans allow tax-free withdrawals, they may be more appropriate for employees who expect to be in a higher income tax bracket during retirement.  High-income earners who make too much to contribute to a Roth IRA may also find the Roth 401(k) attractive, as there are no income limitations for Roth 401(k) participation. The Roth 401(k) option may not be as attractive to someone nearing retirement and expecting to need to tap his or her retirement savings soon. Traditional 401(k) contributions may be more appropriate for employees seeking a tax break at the time of contribution and/or who expect to be in a lower income tax bracket during retirement.

The question as to whether an individual will be in a more or less favorable financial position at retirement by taking advantage of the Roth 401(k) option depends primarily on two factors-the level at which a participant contributes and whether post-retirement tax rates are the same, higher or lower than pre-retirement tax rates.  An individual may wish to contact his or her financial advisor to determine whether to make Roth 401(k) contributions in lieu of or in addition to traditional 401(k) deferrals. Many participants electing Roth 401(k) contributions may contribute less to offset the immediate tax consequence. The chart below illustrates the possible impact on contributions (assuming a 34% tax rate).[1]

 

Pre-Tax Deferrals Roth Deferrals
$ 1,000 $ 660
$ 2,000 $1,320
$ 3,000 $1,980
$ 4,000 2,640
$ 5,000 3,300
$ 6,000 3,960
$ 7,000 4,620
$ 8,000 5,280
$ 9,000 5,940
$10,000 6,600
$11,000 7,260
$12,000 7,920
$13,000 8,580
$14,000 9,240
$15,000 9,900


Assuming investment earnings and tax rates stay the same, Roth 401(k) contributions offset for taxes yield exactly the same after-tax account balance as savings on a pre-tax basis as illustrated below.

Total Deferrals Tax Savings (34%) Account Value at Age 65 Tax Liability (34%) After-Tax Account Value
Traditional $150,000 $51,000 $904,717 $307,604 $597,113
Roth $99,000 $0 $597,113 $0 $597,113


However, participants may be in a lower tax bracket after retirement. When the lower tax bracket is taken into consideration, savings on a pre-tax basis provides a greater benefit at retirement as illustrated below.

Total Deferrals Tax Savings (34%) Account Value at Age 65 Tax Liability (19%) After-Tax Account Value
Traditional $150,000 $51,000 $904,717 $171,896 $732,821
Roth $99,000 $0 $597,113 $0 $597,113


Conversely, a very different scenario emerges if participants elect Roth 401(k) contributions but do not reduce their contribution amounts as illustrated below.

Total Deferrals Tax Savings (34%) Account Value at Age 65 Tax Liability (34%) After-Tax Account Value
Traditional $150,000 $51,000 $904,717 $307,604 $597,113
Roth $150,000 $0 $304,717 $0 $904,717


One important consideration to keep in mind is that some employees may not be able to continue to keep deferral rates the same should they elect to make Roth 401(k) contributions, resulting in overall lower deferral percentages, which could adversely affect nondiscrimination testing results.

For more information on the Roth 401(k) feature, please contact your Plan Consultant at 1-800-872-3473, or visit us at www.pentegra.com.