Tending to the Future

by S. Tracy Braun, president of NPS

Coming Attraction
in 2006: Roth 401(k)

Beginning January 1, 2006, a new feature can be added to your 401(k) plan - the Roth contribution account. Unlike Roth IRAs, there are no individual income limits. Any plan participant is eligible to use this account.

What is a Roth 401(k) contribution?

A Roth 401(k) contribution is very similar to a 401(k) pre-tax employee deferral, except for a few important points:

Roth 401(k) contributions are made after tax, not pre-tax.

Roth 401(k) contributions, plus earnings on those contributions, come out tax-free (if you withdraw after five years and past age 59 1/2).

Because the contributions and earnings on those contributions are tax-free upon withdrawal, this will help avoid tax on Social Security benefits.

How does it work?

If your Plan allows for the Roth Contribution Account, you can elect to defer a portion of your pay into this account. The contributions are not tax- deductible when made; however, no tax is paid on the earnings and no tax is paid on any distribution from this account (if certain distribution rules are met).

You can contribute up to the annual 401(k) limit into the Roth Account. In 2006 this limit will be $15,000. This is substantially higher than the Roth IRA limit of $4,000.

Can I still contribute to my pre-tax 401(k) account?

Yes, you can contribute to your pre-tax 401(k) account or to the Roth account, or to both. However, the total of both accounts cannot exceed the annual limit of $15,000 in 2006. In addition, catch-up contributions (available for those participants over age 50) can be contributed to the Roth account. The catch-up contribution amount in 2005 will be $5,000.

What about distributions from the Roth 401(k) account?

Distributions from the Roth 401(k) account have the same restrictions as a pre-tax 401(k) account. If the plan provides, distributions are allowed upon termination of employment, death, disability, hardship, attainment of age 59 1/2 and plan termination. However, there are special tax rules relative to the Roth 401(k) account:

Contributions always come out tax-free.

Earnings on the contributions are distributed tax-free if you have attained age 59 1/2 or your death or disability occurs, and five years have passed since you started the Roth 401(k) account.

Which account should I choose?

In short, features of the pre-tax 401(k) include pre-tax contributions, tax-deferred earnings and taxable distributions.

The Roth 401(k) features after-tax contributions; tax-free earnings (if withdrawn after five years and after age 59 1/2, death or disability; and tax-free distributions.

There are numerous factors to consider in choosing the Roth account over the pre-tax account, such as your age, when you will need to access your account, your financial circumstances and the future tax rates.

For example, if you believe your tax rate will be lower in retirement than it is now, the pre-tax 401(k) account will allow you more savings. You will not pay taxes now, but will pay taxes when you withdraw the money later. If you believe that your tax rate will be higher when you withdraw the money, under the Roth account you will pay taxes now, and not later when you withdraw the money.

You should consider not only your current tax rate, but also the possibility that Congress will increase tax rates in the future.

What is the impact on Social Security benefits?

Another very important point is that distributions from your Roth Account will help avoid tax on your Social Security benefits. Social Security Benefits are taxable if other taxable income, plus 50 percent of the Social Security benefit exceeds $25,000 (single) or $32,000 (joint). Other taxable income includes any taxable distributions from your 401(k) plan. Since Roth distributions are not taxable, they are not included in this calculation.

What else should I know about the Roth account?

In most ways the Roth account is the same as the pre-tax account. Employer matching contribution may be made on Roth 401(k) contributions; Roth 401(k) accounts are 100 percent vested; a separate account must be maintained for the Roth 401(k) contributions; and loans may be taken from the Roth account, if permitted by the plan. Roth 401(k) distributions can be rolled over to a Roth IRA (no income limits apply). Unlike traditional IRAs, Roth IRAs do not have a required distribution at age 70 1/2.

Who might consider a Roth 401(k) account?

Individuals who might consider a Roth 401(k) include younger employees in lower tax brackets; any employee who thinks tax hikes are inevitable; those who hope to avoid taxes on Social Security benefits; and those who do not want forced distributions at age 70 1/2.

Will all 401(k) plans have this option?

An employer must amend an existing 401(k) plan to include the option to make contributions to a Roth account under the plan. This amendment can specify whether an employee can make a Roth contribution, a pre-tax contribution or both. The Roth contribution will be available for plan years beginning Jan. 1, 2006.

Now is the time to explore adding the Roth 401(k) Account to your Plan. It offers a great new way to save for retirement with tax-free earnings. •

S. Tracy Braun is an enrolled actuary and president of NPS Retirement Plan Consulting.