Roth 401(k)
Encyclopedia
The Roth 401 is a type of retirement
savings plan. It was authorized by the United States Congress
under the Internal Revenue Code
, section 402A, and represents a unique combination of features of the Roth IRA
and a traditional 401(k)
plan. As of January 1, 2006 U.S. employers have been free to amend their 401(k) plan document to allow employees to elect Roth IRA type tax treatment for a portion or all of their retirement plan contributions. The same change in law allowed Roth IRA type contributions to 403(b)
retirement plans. The Roth retirement plan provision was enacted as a provision of the Economic Growth and Tax Relief Reconciliation Act of 2001
(EGTRRA 2001).
plan, introduced by Congress in 1978, employees contribute pre-tax earnings to their retirement plan, also called "elective deferral
s". That is, an employee's elective deferral funds (for tax-year 2012 up to $17,000 per tax year for those under age 50 and $22,500 for those over) are set aside by the employer in a special account
where the funds are allowed to be invested
in various options made available in the plan.
Employers may also add funds to the account by contributing matching funds on a fractional
formula
basis (e.g., matching funds might be added at the rate of 50% of employees' elective deferrals), or on a set percentage basis. Funds within the 401(k) account grow on a tax deferred basis. When the account owner reaches the age of 59-and-a-half, they may begin to receive "qualified distributions" from the funds in the account; these distributions are then taxed at ordinary income
tax rates. Exceptions exist to allow distribution of funds before 59 and a half, such as Substantially equal periodic payments, disability, and separation from service after the age of 55, as outlined under IRS Code section 72(t).
Under a Roth IRA, first enacted in 1998, individuals, whether employees or self-employed, voluntarily contribute post-tax funds to an individual retirement arrangement (IRA). In contrast to the 401k plan, the Roth plan requires post-tax contributions, but allows for tax free growth and distribution, provided the contributions have been invested for at least 5 years and the account owner has reached age 59 and a half. The amounts of income that can be invested in a Roth IRA are significantly more limited than those to a 401(k) are. For 2008, individuals are limited to contributing no more than $5,000 to a Roth IRA, if under age 50, and $6,000, if age 50 or older. Additionally, Roth IRA contributions are prohibited when taxpayers earn a Modified Adjusted Gross Income of more than $110,000, ($160,000 for married filing jointly). See 401(k) versus IRA matrix that compares various types of IRAs with various types of 401(k)s
.
Employers are permitted to make matching contributions on employees' designated Roth contributions. However, employers' contributions cannot receive the Roth tax treatment. The matching contributions made on account of designated Roth contributions must be allocated to a pre-tax account, just as matching contributions are on traditional, pre-tax elective contributions. (Pub 4530)
In general, the difference between a Roth 401(k) and a traditional 401(k) is that the Roth version is funded with after-tax dollars while the traditional 401(k) is funded with pre-tax dollars. After-tax dollars represent money for which taxes are paid in the current year, and pre-tax dollars are those that do not represent federal taxable income in the current year. Typically, the earnings on Roth contributions will be tax free as long as the distribution is made at least 5 years after the first Roth contribution and the attainment of age 59 and one half, unless an exception applies.
A Roth 401(k) plan will probably be most advantageous to those who might otherwise choose a Roth IRA, for example, younger workers who are currently taxed in a lower tax bracket
, but expect to be taxed in a higher bracket upon reaching retirement age. Another consideration for those currently in higher tax brackets is the future of income tax rates in the U.S. (if income tax rates increase, current taxation would be desirable for a wider group). The Roth 401(k) offers the advantage of tax free distribution, but is not constrained by the same income limitations. For example, normal Roth IRA contributions are limited to $5,000 ($6000 if age 50 or order); whereas, up to $16,500 could be contributed to a Roth 401(k) account, provided no other elective deferrals were taken for the tax year (no traditional 401(k) deferrals taken).
Adoption of Roth 401(k) plans has been relatively slow, and stated reasons for this include the fact that they require additional administrative recordkeeping and payroll processing. However some larger firms have now adopted Roth 401(k) plans, and this is expected to spur their adoption by other firms including smaller ones.
Retirement
Retirement is the point where a person stops employment completely. A person may also semi-retire by reducing work hours.Many people choose to retire when they are eligible for private or public pension benefits, although some are forced to retire when physical conditions don't allow the person to...
savings plan. It was authorized by the United States Congress
United States Congress
The United States Congress is the bicameral legislature of the federal government of the United States, consisting of the Senate and the House of Representatives. The Congress meets in the United States Capitol in Washington, D.C....
under the Internal Revenue Code
Internal Revenue Code
The Internal Revenue Code is the domestic portion of Federal statutory tax law in the United States, published in various volumes of the United States Statutes at Large, and separately as Title 26 of the United States Code...
, section 402A, and represents a unique combination of features of the Roth IRA
Roth IRA
A Roth IRA is a special type of retirement plan under US law that is generally not taxed, provided certain conditions are met. The tax law of the United States allows a tax reduction on a limited amount of saving for retirement. The Roth IRA is named for its chief legislative sponsor, Senator...
and a traditional 401(k)
401(k)
A 401 is a type of retirement savings account in the United States, which takes its name from subsection of the Internal Revenue Code . A contributor can begin to withdraw funds after reaching the age of 59 1/2 years...
plan. As of January 1, 2006 U.S. employers have been free to amend their 401(k) plan document to allow employees to elect Roth IRA type tax treatment for a portion or all of their retirement plan contributions. The same change in law allowed Roth IRA type contributions to 403(b)
403(b)
A 403 plan, also known as a tax-sheltered annuity, is a tax-advantaged retirement savings plan available for public education organizations, some non-profit employers , cooperative hospital service organizations, and self-employed ministers in the United States...
retirement plans. The Roth retirement plan provision was enacted as a provision of the Economic Growth and Tax Relief Reconciliation Act of 2001
Economic Growth and Tax Relief Reconciliation Act of 2001
The Economic Growth and Tax Relief Reconciliation Act of 2001 , was a sweeping piece of tax legislation in the United States by President George W. Bush...
(EGTRRA 2001).
Traditional 401(k) and Roth IRA plans
In a traditional 401(k)401(k)
A 401 is a type of retirement savings account in the United States, which takes its name from subsection of the Internal Revenue Code . A contributor can begin to withdraw funds after reaching the age of 59 1/2 years...
plan, introduced by Congress in 1978, employees contribute pre-tax earnings to their retirement plan, also called "elective deferral
Deferral
Deferred, in accrual accounting, is any account where the asset or liability is not realized until a future date , e.g. annuities, charges, taxes, income, etc. The deferred item may be carried, dependent on type of deferral, as either an asset or liability...
s". That is, an employee's elective deferral funds (for tax-year 2012 up to $17,000 per tax year for those under age 50 and $22,500 for those over) are set aside by the employer in a special account
Account
Accounting is a systematic way to record transactions.An Account refers to assets, liabilities, income, expenses, and equity, as represented by individual ledger pages, to which changes in value are chronologically recorded with debit and credit entries. These entries, referred to as postings,...
where the funds are allowed to be invested
Investment
Investment has different meanings in finance and economics. Finance investment is putting money into something with the expectation of gain, that upon thorough analysis, has a high degree of security for the principal amount, as well as security of return, within an expected period of time...
in various options made available in the plan.
Employers may also add funds to the account by contributing matching funds on a fractional
Fraction (mathematics)
A fraction represents a part of a whole or, more generally, any number of equal parts. When spoken in everyday English, we specify how many parts of a certain size there are, for example, one-half, five-eighths and three-quarters.A common or "vulgar" fraction, such as 1/2, 5/8, 3/4, etc., consists...
formula
Formula
In mathematics, a formula is an entity constructed using the symbols and formation rules of a given logical language....
basis (e.g., matching funds might be added at the rate of 50% of employees' elective deferrals), or on a set percentage basis. Funds within the 401(k) account grow on a tax deferred basis. When the account owner reaches the age of 59-and-a-half, they may begin to receive "qualified distributions" from the funds in the account; these distributions are then taxed at ordinary income
Ordinary income
Under the United States Internal Revenue Code, the type of income is defined by its character. Ordinary income is usually characterized as income other than capital gain...
tax rates. Exceptions exist to allow distribution of funds before 59 and a half, such as Substantially equal periodic payments, disability, and separation from service after the age of 55, as outlined under IRS Code section 72(t).
Under a Roth IRA, first enacted in 1998, individuals, whether employees or self-employed, voluntarily contribute post-tax funds to an individual retirement arrangement (IRA). In contrast to the 401k plan, the Roth plan requires post-tax contributions, but allows for tax free growth and distribution, provided the contributions have been invested for at least 5 years and the account owner has reached age 59 and a half. The amounts of income that can be invested in a Roth IRA are significantly more limited than those to a 401(k) are. For 2008, individuals are limited to contributing no more than $5,000 to a Roth IRA, if under age 50, and $6,000, if age 50 or older. Additionally, Roth IRA contributions are prohibited when taxpayers earn a Modified Adjusted Gross Income of more than $110,000, ($160,000 for married filing jointly). See 401(k) versus IRA matrix that compares various types of IRAs with various types of 401(k)s
401(k) IRA matrix
This is a comparison between 401, Roth 401, and Traditional Individual Retirement Account and Roth Individual Retirement Account accounts, four different types of retirement savings vehicles that are common in the United States.-Comparison:...
.
The Roth 401(k) plan
The Roth 401(k) combines some of the most advantageous aspects of both the 401(k) and the Roth IRA. Under the Roth 401(k), employees can decide to contribute funds on a post-tax elective deferral basis, in addition to, or instead of, pre-tax elective deferrals under their traditional 401(k) plans. An employee's combined elective deferrals-- whether to a traditional 401(k), a Roth 401(k), or to both-- cannot exceed $16,500 for tax year 2011 if a participant is under 50; if they are over 50, they may contribute an additional $5,500. Employer's matching funds are not included in the $16,500 elective deferral cap, but are considered for the maximum section 415 limit, which is $49,000 for 2011.Employers are permitted to make matching contributions on employees' designated Roth contributions. However, employers' contributions cannot receive the Roth tax treatment. The matching contributions made on account of designated Roth contributions must be allocated to a pre-tax account, just as matching contributions are on traditional, pre-tax elective contributions. (Pub 4530)
In general, the difference between a Roth 401(k) and a traditional 401(k) is that the Roth version is funded with after-tax dollars while the traditional 401(k) is funded with pre-tax dollars. After-tax dollars represent money for which taxes are paid in the current year, and pre-tax dollars are those that do not represent federal taxable income in the current year. Typically, the earnings on Roth contributions will be tax free as long as the distribution is made at least 5 years after the first Roth contribution and the attainment of age 59 and one half, unless an exception applies.
A Roth 401(k) plan will probably be most advantageous to those who might otherwise choose a Roth IRA, for example, younger workers who are currently taxed in a lower tax bracket
Tax bracket
Tax brackets are the divisions at which tax rates change in a progressive tax system . Essentially, they are the cutoff values for taxable income — income past a certain point will be taxed at a higher rate.-Example:Imagine that there are three tax brackets: 10%, 20%, and 30%...
, but expect to be taxed in a higher bracket upon reaching retirement age. Another consideration for those currently in higher tax brackets is the future of income tax rates in the U.S. (if income tax rates increase, current taxation would be desirable for a wider group). The Roth 401(k) offers the advantage of tax free distribution, but is not constrained by the same income limitations. For example, normal Roth IRA contributions are limited to $5,000 ($6000 if age 50 or order); whereas, up to $16,500 could be contributed to a Roth 401(k) account, provided no other elective deferrals were taken for the tax year (no traditional 401(k) deferrals taken).
Adoption of Roth 401(k) plans has been relatively slow, and stated reasons for this include the fact that they require additional administrative recordkeeping and payroll processing. However some larger firms have now adopted Roth 401(k) plans, and this is expected to spur their adoption by other firms including smaller ones.
Additional considerations
- Roth 401(k) contributions are irrevocable, such that once money is invested into a Roth 401(k) account; it cannot be moved to a regular 401(k) account.
- Employees are able to roll their Roth 401(k) contributions over to a Roth IRARoth IRAA Roth IRA is a special type of retirement plan under US law that is generally not taxed, provided certain conditions are met. The tax law of the United States allows a tax reduction on a limited amount of saving for retirement. The Roth IRA is named for its chief legislative sponsor, Senator...
account upon termination of employmentTermination of employment-Involuntary termination:Involuntary termination is the employee's departure at the hands of the employer. There are two basic types of involuntary termination, known often as being "fired" and "laid off." To be fired, as opposed to being laid off, is generally thought of to be the employee's...
. - It is the employer's decision as to whether the company will provide access to the Roth 401(k) in addition to the traditional 401(k). Many employers may feel that the added administrative burden outweighs the benefits of the Roth 401(k)
- The Roth 401(k) plan will continue to be available after December 31, 2010 due to the Pension Protection Act of 2006Pension Protection Act of 2006The Pension Protection Act of 2006 , 120 Stat. 780, was signed into law by U.S. President George W. Bush on August 17, 2006.-Pension reform:...
that was passed to extend the program. Originally, the program was set up to sunsetSunset provisionIn public policy, a sunset provision or clause is a measure within a statute, regulation or other law that provides that the law shall cease to have effect after a specific date, unless further legislative action is taken to extend the law...
, or no longer be in place, after 2010 along with the rest of EGTRRA 2001. - Unlike Roth IRAs, owners of Roth 401(k) accounts (designated Roth accounts) must begin distributions upon reaching age 70 and a half, similar to required minimum distributions for IRA and other retirement plans. (Pub 4530)
See also
- 401(k)401(k)A 401 is a type of retirement savings account in the United States, which takes its name from subsection of the Internal Revenue Code . A contributor can begin to withdraw funds after reaching the age of 59 1/2 years...
- 401(k) IRA matrix401(k) IRA matrixThis is a comparison between 401, Roth 401, and Traditional Individual Retirement Account and Roth Individual Retirement Account accounts, four different types of retirement savings vehicles that are common in the United States.-Comparison:...
- 401k & IRA comparisons (401k vs Roth 401k vs Traditional IRA vs Roth IRA) - 403(b)403(b)A 403 plan, also known as a tax-sheltered annuity, is a tax-advantaged retirement savings plan available for public education organizations, some non-profit employers , cooperative hospital service organizations, and self-employed ministers in the United States...
- Individual Retirement AccountIndividual Retirement AccountAn individual retirement arrangement is the blanket term for a form of retirement plan that provides tax advantages for retirement savings in the United States...
- Internal Revenue ServiceInternal Revenue ServiceThe Internal Revenue Service is the revenue service of the United States federal government. The agency is a bureau of the Department of the Treasury, and is under the immediate direction of the Commissioner of Internal Revenue...
- Rollovers as Business Start-UpsRollovers as Business Start-UpsROBS is an arrangement in which prospective business owners use their 401 k retirement funds to pay for new business start-up costs. ROBS is an acronym from the United States Internal Revenue Service for the IRS ROBS Rollovers as Business Start-Ups Compliance Project.ROBS plans, while not...
- Self-Directed IRASelf-Directed IRAA Self-Directed Individual Retirement Arrangement is an IRA that requires the account owner to make investment decisions and investments on behalf of the retirement plan. IRS regulations require that either a qualified trustee, or custodian hold the IRA assets on behalf of the IRA owner...