March Madness: Tournament or Tax Time?

Thu, 19 Feb 2009 14:40:19 -0400

Taking a look at the new Roth 401(k) option

For some, the term "March Madness" refers to a three-week period during which 65 college basketball teams from across the country play their way to becoming NCAA Men's Division I Champions. But for others, it represents the frenzy of tax-filing time.

Aside from the flurry of compiling the previous year's paperwork and expenses, the approach of April 16th causes many to reflect on their overall tax planning and retirement strategies. We all want to be sure we are effectively reducing taxable income by maximizing our contributions to our 401(k) plan.

Now there is an additional retirement strategy in the mix: the Roth 401(k). Employers wonder if they should offer it to their employees. Employees wonder if they should add this new feature to their current 401(k) plan. To understand if the Roth 401(k) makes sense for you, first consider the facts.

The Roth 401(k) combines elements of the traditional 401(k) with the tax benefits of the Roth IRA. Like a traditional 401(k), it allows people to contribute to tax-deferred savings accounts. Like a Roth IRA, contributions come from after-tax dollars in exchange for the benefit of withdrawing that money tax-free in retirement. Conversely, traditional 401(k) contributions come from pre-tax dollars and future withdrawals are taxed as income.

Adopting the Roth 401(k) option may be a chance for employers and employees to add significantly to retirement savings. While Roth IRAs impose strict income limitations ($160,000 adjusted gross income for married couples; $110,000 for singles) making them unavailable to some, the Roth 401(k) has no income limitation to participate. This alone will allow many more individuals to begin benefiting from having investments that grow tax-free. In addition, the total annual employee contribution limit on a Roth 401(k) for 2007 is $15,500 (or $20,500 if you are 50 or older), much greater than the 2007 limit of $4,000 for traditional 401(k) and Roth IRA accounts. But how will employers know if their employees will be interested in this new option?

Understanding the New Roth 401(k)-

To better understand the potential impact of offering a Roth 401(k) option to plan participants, we have assembled answers to some of the most frequently asked questions about the Roth 401(k). To read the answer to any of these questions click here.

What is the difference between a traditional 401(k) and a Roth 401(k)? The Roth 401(k) is funded with after-tax contributions while the traditional 401(k) is funded with pre-tax contributions. In other words, with a Roth 401(k) you pay taxes today in return for a tax-free status in retirement. A traditional 401(k) saves you taxes today, but withdrawals are taxed in retirement.

How much can be contributed in a given year? The total annual employee contribution limit on a Roth 401(k) for 2007 is $15,500 (or $20,500 if you are 50 or older).

Can I contribute $15,500 per year to both a traditional 401(k) and a Roth 401(k)? The combined amount contributed to all designated Roth accounts and traditional, pre-tax accounts in any one year for any individual is limited to $15,500 (or $20,500 if you are 50 or older).

Can employer matching contributions go into a Roth 401(k)? If an employer provides a matching contribution to a Roth 401(k), two accounts are set up for each participant. The first contains the employee’s after-tax contributions that will be distributed tax free. The second account contains the employer’s before-tax contributions and any investment growth; these funds are taxable when distributed.

Can I have both a Roth IRA and a Roth 401(k)? Yes, and as with a Roth IRA account, you contribute to a Roth 401(k) with after-tax dollars. Employees who are eligible for the Roth 401(k) will be able to set aside more money for retirement than they would if they relied solely on an IRA because contribution limits are much higher for the 401(k) plans.

Can I switch my contributions back and forth between my Roth 401(k) and my traditional 401(k)? Contributions are non-transferable. Employees will be able to contribute to one or both accounts, but they can't switch money from one plan to the other after it goes in.

Do minimum distribution rules differ between the Roth IRA and the Roth 401(k)? The minimum distribution rules that apply to traditional IRAs (participants must take minimum distributions beginning the year after they turn 70 ½ ) do not apply to Roth IRAs. The minimum distribution rules do apply to the Roth 401(k), but this is not a significant problem. At retirement, employees may roll a Roth 401(k) account into a Roth IRA where the minimum distribution rules won't apply.

Do my contributions begin growing tax-free immediately? Earnings on Roth 401(k) deferrals will be tax-free if the contributions remain in the plan for at least five years after inception of the Roth option, and the participant does not take withdrawals before attaining age 59½ (taxes and penalties are waived if a participant dies or is disabled).

Does the employer plan need to be amended to include the Roth 401(k)? Yes. Employers will need to formally amend traditional 401(k) plans to add the Roth option.

Are employers required to offer the Roth 401(k)? Employers are not obligated to offer the Roth 401(k) option to plan participants. However, an individual is only eligible for participation in a Roth 401(k) if they currently participate in their employer's 401(k) plan and the employer has chosen to offer the Roth option.

Telamon Insurance & Financial Network: Newton MA

March Madness: Tournament or Tax Time?