Joseph Heneghan No Comments

The Roth 401(k) plan — a combination of popular 401(k) accounts for employees and the Roth IRA concept for individuals — has been relatively slow to catch on in the workplace. But the federal government is now offering this hybrid retirement savings option to its 3.3 million U.S. government workers*

If it’s good enough for Uncle Sam, does the setup make sense for your business operation? It may be time to take a closer look.

Differences and Similarities

Roth 401(k) 401(k) Plan Roth
Contributions made with After-tax dollars Pre-tax dollars After-tax dollars
Withdrawals If qualified, free from federal and possibly state tax Taxed If qualified, free from federal and possibly state tax
Contribution limits in 2019 Up to $19,000 or $25,000 for those age 50 or older at year-end (up from $18,500 and $24,500 respectively in 2018)   Up to $19,000 or $25,000 for those age 50 or older at year-end (up from $18,500 and $24,500 respectively in 2018)  Up to $6,000 or $7,000 for those age 50 or older at year-end  (up from $5,500 and $6,500 respectively in 2018)
Withdrawal requirements under the minimum distribution rules Must start taking at age 70 1/2 Generally must start taking at age 70 1/2 None — can leave account untouched and pass on to heirs.
None to participate None to participate Cannot contribute if income is above certain limits. 2019 phaseout begins at $193,000 AGI for married filing jointly and $122,000 for single and household head (up from $189,000 and $120,000 respectively in  2018).

Surprisingly, the Roth 401(k) has been around for a while. It was initially authorized by the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) but didn’t officially become available until 2006. Under EGTRRA, this provision was scheduled to expire after 2010, but it was made permanent and enhanced by subsequent legislation. The IRS has also issued regulations governing its use. Most of the usual nondiscrimination requirements for regular 401(k) plans also apply to Roth 401(k)s.One survey indicates that 39% of employers with retirement plans offer a Roth 401(k) option, with 29% more likely to add it this year. Approximately 6% of the eligible workers are taking advantage of this feature.

The plan works pretty much like the name implies. As with a regular 401(k) plan, an eligible employee can elect to defer part of his or her salary to a separate account, subject to the generous annual limits in the law. The company may also provide matching contributions based on a percentage of salary.

For 2019, a participating employee can contribute up to $19,000 in elective deferrals, increased to $25,000 for someone age 50 or over (up from $18,500 and $24,500 respectively in 2018). In comparison, contributions to a Roth IRA established outside the workplace are limited to $6,000 in 2019; $7,000 for those age 50 or over (unchanged from 2018).  Also, the ability to contribute to a Roth IRA is phased out for high-income taxpayers.

For 2019, the phase-out begins at $122,000 of modified adjusted gross income (MAGI); $193,000 of MAGI for joint filers (up from $120,000 and $189,000 respectively in 2018).

But here’s where the Roth 401(k) takes a marked departure from regular 401(k)s. Contributions to the employee’s account are made with after-tax dollars rather than pre-tax dollars. Thus,an employee loses a key current tax benefit of 401(k)s.

On the plus side, when an employee withdraws funds from the account, “qualified distributions” are completely exempt from income tax, just like qualified distributions from a Roth IRA. In contrast, regular 401(k) distributions are taxed at ordinary income rates.

For this purpose, “qualified distributions” include distributions that are:

  • Made after the participant has reached age 59 1/2;
  • Paid on account of death or disability; or
  • Used to pay for “first-time homebuyer expenses” (up to a lifetime limit of $10,000).

In other words, there’s a trade-off. A participant in a Roth 401(k) gives up the ability to contribute to the account on a pre-tax basis in return for the lure of receiving tax-free payments in the future. For many workers, it’s a good deal, especially if you are restricted from making Roth IRA contributions due to the annual income limits.

Of course, every situation is different. An employee must consider all the relevant factors, including his or her current and anticipated tax rates in retirement and the desire for current tax breaks. Switching from a traditional 401(k) plan to a Roth 401(k) means a cut in take-home pay.

Finally, under a tax law change, 401(k) participants can roll over pre-tax balances to a Roth account, effective as of September 27, 2010. This generally consists of the balance in a 401(k) account with elective deferrals, matching contributions and earnings. The rollover is taxable except to the extent it represents any after-tax contributions.

Is the Roth 401(k) option a good fit for you and your company? Consult with your tax and employee benefits advisers for more information.

*The “Roth TSP” (Thrift Savings Plan) is the equivalent of a Roth 401(k) for private sector employees, and is now available to federal civilian employees and members of the uniformed services.

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