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New Retirement Option – Roth 401k Explained

Posted By Jim On 07/23/2005 @ 8:14 am In Investing,Personal Finance,Retirement | 11 Comments

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 [3] 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  • Money can be withdrawn without any fees if you are over 59.5 and have had the money in there for at least five years (psuedo-Roth IRA rules).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 [4] of these new plans.

If you’re interested in reading the nitty gritty details, the Roth 401(k) Website [5] 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 [6] 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.

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[1] Tweet: http://twitter.com/share

[2] Email: mailto:?subject=http://www.bargaineering.com/articles/new-retirement-option-roth-401k.html

[3] headline article: http://money.cnn.com/2005/07/21/retirement/new_401k/index.htm?cnn=yes

[4] article weighing the pro’s and con’s: http://money.cnn.com/2005/07/21/retirement/roth_401k/

[5] Roth 401(k) Website: http://www.roth401k.com

[6] nickel: http://www.bargaineering.com/articles/new-retirement-option-roth-401k.html#comment-379

Thank you for reading!