The Pension Protection Act of 2006 made Roth 401(k)s a permanent retirement option.
While the Pension Protect Act lifted the cloud of uncertainty surrounding Roth 401(k) contributions by making them permanent, whether employers will change existing 401(k) plans to adopt the option remains to be seen.
Benefits experts seem to agree that the amount of employee demand will determine how many employers adopt the Roth 401(k), which combines several features of the Roth IRA with the employer maintained 401(k). Like a Roth IRA, contributions to Roth 401(k)s are made after taxes. At age 59 ½ you can begin to withdraw your savings without facing taxes or penalties, provided you have held the account for at least five years. Minimum distributions are required to begin at age 70½, like a 401(k).
Roth 401(k)s face the same contribution limits as regular 401(k)s: for 2007, $15,500 a year or $20,500 a year if you’re over age 50. Regular 401(k) contributions and Roth 401(k) contributions are combined for calculating the contribution limit. Roth IRAs limit you for 2007 to only $4,000 a year in contributions or $5,000 if you’re over 50.
Roth 401(k) have no annual income limit, whereas the Roth IRA begins reducing the contribution limit for singles making $99,000 a year and couples making $156,000. The contributions are eliminated when income reaches $114,000 for singles and $166,000 for couples.
If withdrawals are made before age 59½ or from accounts less than five years old, the account holder pays no tax on the original after-tax contributions, but will pay income tax and a 10-percent penalty on earnings. After-tax contributions are withdrawn first, so no taxes or penalties are due until the account holder starts tapping earnings.
An employer must offer a regular 401(k) plan to offer the Roth 401(k) contribution options. Because 401(k) contributions are made pre-tax, and Roth 401(k) contributions are made after tax, the amounts are segregated. Employers may match Roth 401(k) contributions, but those are held in another separate account and are considered earnings for tax and penalty purposes.
Roth 401(k) options work well for high-compensation employees who anticipate being in a higher tax bracket during retirement, who can pay taxes now at a lower rate and then make withdrawals tax free in retirement. They may also be attractive to employees whose income prevents them from making contributions to a Roth IRA. If the funds will be needed sooner than five years, however, the Roth IRA probably isn’t the best option.
At the other end of the spectrum, Roth 401(k)s may be an alternative for parents in the low tax brackets, because they may have large deductions for child care and home ownership now that may not be available to them in retirement. These families may also anticipate being in a higher tax bracket in retirement.
As with all investment decisions, deciding to invest in a Roth 401(k) has many variables to consider including the number of years you plan on holding assets in the account, your current tax bracket, and your future tax bracket. It also depends on whether or not your employer decides to establish the option. After working with a financial professional, you should take all of your personal and financial factors into consideration before investing.