What is a Roth 401(k)? Is it like a Roth IRA? Who can contribute? Am I limited to $95,000 of income to contribute? These are all common questions and there is a lot of confusion out there. Let’s take a look at what really is going on.
A Roth IRA is a qualified retirement vehicle for individuals that is like a traditional IRA in that you can make a $4,000 annual contribution. But with a Roth IRA you make your contributions with after tax dollars. Like a traditional IRA, the earnings grow tax deferred, but assuming that you follow the rules, leave the investment earnings in for a minimum of 5 years is one of the rules and you do not take distributions of the investment earnings until at least age 59 ½*, then there is no tax, zero, on any withdrawals. And you are not required to make any minimum distributions. A good deal for the young, but the catch is that your are not eligible unless your income is under $95,000 as an individual or $150,000 as a couple**. Why do I say a good deal for the young? Well many young people, especially single, can afford to put away that amount of money, they are not yet earning over the $95,000 and perhaps they are not in a very high tax bracket. Say they put in $3,000 per year for 7 years, starting at age 25. Then they exceed the earnings limit, so no more contributions can go in. They leave the assets in the Roth IRA to grow over the next 33 years, to their age 65, and they average 8% earnings on their investment. At age 65 they will have $328,970.84, and they invested only $21,000. Voila - $307,970.84 of tax free earnings! A good deal for the young person that is not making over $95,000.
Now – the Roth 401(k)! First of all, the advantage for the young person remains the same. But the first change is that the limit that you can contribute goes from the $4,000 per year to $15,000 (or $20,000 if you are age 50 or older) per year. But the person making less than $95,000 the increase may not matter that much, they can’t afford to contribute much more than the $4,000, but wait! The second change is that there in no income limitation! Yes, if you are making $200,000 or more, you may take advantage of it. There is no limit! Now let’s think for a minute, first of all there are a lot of younger folks out there making in excess of the $95,000 per year, especially in California. You do the math, it can be a very big number if you are young, pay your tax now and let it grow, grow, grow. Well that is great for the young person, but what about those of us that are up there in age?
There are several potential advantages for the older wage earner, especially the older high income wage earner. First if you are 50 year old or more, you may contribute up to $20,000 per year to the Roth 401(k). Yes, it does include the “catch-up” provision. The second potential advantage is that many people feel that we currently in a low tax rate environment. The maximum personal Federal tax rate is 35%. The Federal Government is currently operating at a substantial deficit and our National Debt is growing rapidly. Do you really think that taxes are not going to go up over the next ten to fifteen years? Pay your taxes now at the lower rate, and take it out at the higher rate – tax free! And believe it or not, if the tax rates stay the same, then you break even. The only way to loose is if tax rates go down. Your guess is as good as mine.
Finally, there is a potential advantage for the high earner that may not need all or part of their assets in their retirement plan to live on and would like to pass it on to heirs. Say a grandchild. Well remember, in a 401(k) plan, you must start taking out “minimum” distributions at age 70 ½. Here is what is possible with a Roth 401(k) for that person. When they stop working, they are allowed to start a Roth IRA and roll the assets from their Roth 401(k) plan into it. There are not minimum distributions from a Roth IRA, so they name their grandchild (or great grandchild) as their beneficiary and low and behold, the grand child leaves the assets in the inherited Roth IRA until they are 55 or 60, they will be able to afford to retire at a younger age with the assets accumulated in this Roth IRA. It will be a very big number. People are using this concept as an estate planning tool.
So what is the downside to the Roth 401(k). It could be confusing! Well education is the answer here. Explain the Roth 401(k) plan well and the confusion factor can be overcome. Tax rates go down, a potential deal breaker. And there is one other potential problem. As written now, this availability of the Roth 401(k) expires in 2010. So it may be only five (5) years that it will work. Well if in fact it expires, you were able to get five (5) years in. And traditionally the IRS has grandfathered this type of program in for those who took advantage of it, but no guarantees. And there is a lot of talk in Congress now to make this permanent. One other question that comes up is about the employer match (if applicable), would the employer match a Roth 401(k) contribution? The answer is yes, the match would continue to go into a before tax bucket of money, but it would still go in. No problem!
So in my opinion, everyone wins with a Roth 401(k)!
* I have intentionally noted a couple of the rules of a Roth IRA, however, you should carefully read and understand all of the rules if you think you may be interested in these plans.
** The Income limitation rules are approximate. Again, you should carefully read and understand all of the rules if you think you may be interested in these plans.