Monday, May 09, 2005

Roth 401(k) - Not a mistype, but a new type of Retirement Plan

Starting in January, 2006, the Federal Government will allow a new type of employer sponsored retirement plan - a Roth 401(k). This new plan combines the unique qualities of a Roth IRA, primarily after-tax contributions in return for tax free earnings and withdrawals, with the ease of employer sponsored and paycheck deducted plan.

In a traditional 401(k), contributions are made on a pre-tax basis. The contributions, and the earnings on them, are subject to income tax upon withdrawal. If you withdraw the funds, you pay the income tax. If your beneficiary withdraws the funds, they pay the income tax. You must withdraw the funds starting age 70 1/2 and start paying tax on them, whether you need the fading or not. Since the balance of the 401(k) is including in your estate, depending on the size of your estate, estate tax may be due at your death, and an additional income tax upon withdrawal.

A Roth 401(k) will have similar contribution and distribution rules to a Roth IRA. Contributions will be made on an after tax basis. There are contribution limits similar to a 401(k) (up to $15,000 per year - $20,000 if you are 50 or older). In addition, there are income restrictions - if you make too much money (($110,000 for single individuals, $160,000 for married individuals) you will not be qualified to create a Roth 401(k). All "qualified" distributions will be made tax free - on a participant's termination of employment, death, disability, attainment of age 59½ (if permitted under the terms of the plan), or hardship.

Note there are two areas relevant to distributions where the Roth 401(k) differs from the Roth IRA. First, a first time home purchase is not a qualified distribution under a Roth 401(k), but is under a Roth IRA. Second, a Roth 401(k) is subject to the same minimum distribution rules starting at age 70 1/2 as a traditional 401(k) - a traditional Roth IRA does not have any minimum distribution requirement.

For employers, you need to investigate what type of benefit this might be for you to attract and retain quality employees. While the Roth 401(k) will create a second set of administrative requirement, the tradeoff might be worthwhile, especially if (i) interest in the new Roth 401(k) increases overall employee contributions, thus increasing or removing any limitations there might be on your own contributions, and (ii) a third party administrator packages the plan as part of your current employee benefits offering.

For employees, speak to your financial advisor to see what benefits this new type of retirement plan might offer for you.

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