Investing, Personal Finance, Retirement 

New Retirement Option – Roth 401k Explained

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You probably know about Roth IRAs (post-tax dollars grow tax-free) and you probably know about 401(k)’s (pre-tax dollar growth to be taxed on disbursement), but what if the two gave birth to a kid? Then you’d have the new Roth 401(k) (it may be renamed to the Roth ESRA) that will come screaming out the gates January 1st, 2006 (the plans were authorized all the way back in 2001). There are still some details to be ironed out by the IRS in the months to come but below I’ll detail some of the key features that everyone is sure about and how this option (which can be used in addition to your current retirement accounts) may be a good one for you.

This article was originally published two months (5/18) ago but I pushed it up to the top since CNNMoney had a headline article about these new plans recently.

  • The Roth 401(k) contributions are post-tax dollars and are separate from your contributions to the 401(k) or Roth.
  • Maximum contribution limits follow 401(k) rules – so in 2006, you may contribute up to $15,000 post-tax dollars to this account.
  • Company matching dollars are pre-tax and go to regular 401(k) accounts.
  • Roth 401(k) eligibility rules follow 401(k) rules, so folks not eligible for Roth IRAs because of income can contribute to the new Roth 401(k).
  • Contributions are irrevocable – This is the huge difference between the Roth IRA and the Roth 401(k), once money goes into the Roth 401(k) it falls under 401(k) rules. With a Roth IRA, you can change your mind and withdraw contributions without penalty – for the Roth 401(k), you will be penalized for withdrawing your contributions, unless…
  • Money can be withdrawn without any fees if you are over 59.5 and have had the money in there for at least five years (psuedo-Roth IRA rules).
  • Forced minimum disbursements at 70.5 – this matches 401(k) rules. Roth IRA has no forced minimum disbursement requirements.
  • Rollover Roth 401(k) to Roth IRA on retirement or termination

Conventional wisdom, for young employees, is to contribute the minimum to earn the company match into your 401(k), then contribute up to the maximum of your Roth IRA, and then push the remainder of your retirement savings into the 401(k). Where does the Roth 401(k) fall in? If you optimistically believe that your income tax rate will be much higher later, you would do the following:

  1. Minimum matching amount for 401(k) – Variable amount (50 cents to the dollar up to 6% of my salary for me, so 3%)
  2. Max Roth IRA – $4,000 in 2006
  3. Max Roth 401(k) – $15,000 in 2006

Are there any downsides to the Roth 401(k)? Not being able to withdraw post-tax contributions as you can with the Roth IRA means it’s not as flexible, but you shouldn’t be withdrawing from your retirement anyway. If you can’t afford to save it for retirement, don’t put it in there in the first place. Your retirement accounts should be untouchable under you actually retire – otherwise you’re cheating future self. If you’re curious, CNN Money has this article weighing the pro’s and con’s of these new plans.

If you’re interested in reading the nitty gritty details, the Roth 401(k) Website has some great resources including recent developments – Rep. Benjamin L. Cardin, a Democrat from my own state, wants to repeal it on the grounds that the retirement products market is “swamped” and will cost the government money. I recommend reading all the articles on that site and consulting with a financial advisor before making any changes to your retirement allocations to ensure you’re doing the right thing for yourself.

Oh, and those of you eligible for 403(b) plans (as nickel asked about), there is also a Roth 403(b) plan that is like the 401(k) plan except it, obviously, follows the 403(b) guidelines and not the 401(k) guidelines. You can read about those at the site above also.

{ 11 comments, please add your thoughts now! }

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11 Responses to “New Retirement Option – Roth 401k Explained”

  1. nickel says:

    Any idea if there will be a 403(b) version?

  2. jim says:

    Thanks for the reminder nickel, I added a little update… but essentially there will be a Roth 403(b) version too. This all, of course, hinges on whether or not your employer will even offer the plans.

  3. ncnblog says:

    Hay, just found your site. Great, great stuff. I have blog-rolled you. Check out my site and see what you think. Keep up the great, informative work.

  4. Monty Loree says:

    I’m Canadian…. what’s a 401k?

  5. jim says:

    A 401(k) is a retirement plan named after the IRS code section that permits it. Essentially it allows you to contribute money, pre-tax, to a retirement account and typically your employer will provide a small percentage match. For me, when I contribute 6% of my salary, I receive a 3% contribution from my company.

  6. thc says:

    I’m afraid there won’t be loads of employers who take the time and effort to add the Roth component to their 401(k)s. I hope that I’m wrong.

  7. JimL says:

    Bad news for government employees: Participants in the 401(k) “equivalent” known as 457(b) are out of luck, apparently. Some time ago I made an inquiry on this and got a reply from a Washington lawyer “close to the situation.” He told me that 457(b) plans either weren’t part of the conversation when the law was drafted, or it was determined that the cost would be too great.

    And THC, I hope you’re wrong, too.

  8. jim says:

    why don’t you think employers would implement it?

  9. Another Bean Counter says:

    Hey Jim. I’ve read your blog a couple of times.

    About the Roth 401(k) you said that you can still contribute the maximum limits for both a Roth 401(k) and a regular 401(k), right? From what I’ve read and understood an individual will not be able to contribute the max to other retirement accounts and still contribute the max to a roth 401(k), (once it becomes available). There are certain limitations, aren’t there? What do you think?

  10. jim says:

    Another Bean Counter,
    Glad to have you back 🙂

    It appears that you’re right, when I read that it was separately tracked I thought it meant that included the totals – but according to the CNN Money article, and closer examination of the regulations, it appears that your total Roth and Regular 401(k) contributions are capped at $15k. That is, of course, if your employer adds the Roth option. I’ll be amending the article to reflect that, Thanks!

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