Wildly popular now, the Roth 401k is still the new kid on the block in the world of retirement plans. The concept has been around for a while now, but the adoption of the feature is still fairly new.
Provisions for the Roth 401k were spelled out in the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA 2001), and allowed plans to adopt the feature starting January 1st, 2006.
There weren’t many early adopters of this provision, however. Some plans were reluctant to adopt the provision because they were unsure of the popularity it would have with their employees. Also, adding a new source of payroll deductions also carried with it the need for payroll re-programming, whether internally in the HR department, or externally, through a payroll provider – and usually both.
Many record keepers (a.k.a. 401k providers) were also unprepared to implement the Roth features. The extent to which the record keeping systems had to be re-programmed was incredible to say the least, not to mention expensive. 401k providers shared similar concerns as the plan sponsors as to whether the Roth 401k would find a home within the defined contribution world. If it didn’t, systems would have been re-programmed for nothing. As such, some 401k providers took a back seat and monitored the results from other providers.
Needless to say, the Roth 401k concept picked up momentum and many plan sponsors and providers began offering it. While the overall adoption rate is still relatively low in general (somewhere between 12-15%) more and more plans are adding the feature as time goes on.
Check with your employer or 401k provider to see if the Roth feature is available to you. If it is, chances are that it’s a good option for you to invest in.
What is a Roth 401k?
The Roth 401k combines the best features of a Roth IRA and 401k plan into one vehicle.
In a standard 401k plan, your employee deferrals are made on a pretax basis. In other words, you reduce your current taxable income by the amount of your contributions. Over the years, you earn money on your money, and those earnings grow tax-deferred as well. But, when retirement comes, it’s time to pay the piper. You will owe taxes on all distributions you take from your standard 401k.
Money in a Roth essentially works just the opposite. All contributions made to it are taxed BEFORE they come out of your paycheck. In other words, you get no immediate tax break on your contributions like you do in a standard 401k. But, just like the standard 401k, the earnings grow tax-deferred.
So what’s the difference between Roth contributions and regular after-tax contributions, you ask?
With regular after-tax money, you will still owe taxes on any earnings those after-tax contributions have made. With Roth money, however, you owe NO taxes on any earnings your contributions make. And if you contribute for a long time, that’s a lot of money you will receive tax free in retirement!
Okay, so there’s a catch (and there’s always a catch, right?) You have to hold the account for a minimum of 5 years AND you have to be age 59 ½ when you take distributions to qualify for the non-taxed earnings. (Note that you and/or your beneficiaries can take distributions tax free if you become totally disabled or you die.) The same rule holds true for a Roth IRA, too. There are no differences here.
But think about it. This is an account that is intended for retirement. So it shouldn’t be that hard to not touch it until you are 59 ½, right? Good.
The 1st year of the 5-year-rule begins on January 1st of the year you make your first Roth contribution, even if you start late and your first contribution doesn’t actually hit your account until December 31st.
How much can I contribute to a Roth 401k?
The amount you can contribute to a Roth 401k vs. the amount you can contribute to a Roth IRA is substantially larger, which is part of what makes it so appealing.
While the contribution limit to a Roth IRA is $5,000 in 2012 (plus a $1,000 catch-up contribution if you are over age 50), the contribution limit to a Roth 401k is that same as that to a regular 401k: $17,000 in 2012, plus $5,500 for catch-up if you are over age 50.
The same 402g limits apply to both pretax contributions to a 401k and Roth contributions. This is $17,000 total, not $17,000 to each type.
The benefit to these larger contributions, of course, is that by packing away more in Roth contributions you will have more to withdrawal tax free during retirement. Not to mention that the power of compounding has more money to work its magic on.