United States: The Roth 401(k) Offers New and Exciting Opportunities

Last Updated: July 11 2006

Roth IRAs have been popular since their introduction in 1998 because the earnings on funds invested in such accounts build up tax free, as opposed to merely tax deferred as in traditional IRAs. However, many people do not have Roth IRAs, either because their income is above the Roth IRA contribution limit (which generally ranges from $110,000 to $160,000, depending on filing status) or because they do not have any funds available to make Roth IRA contributions after funding their 401(k) or other retirement plans. Fortunately, this accessibility issue has dramatically improved.

The Economic Growth and Tax Relief Reconciliation Act of 2001 provides that beginning in 2006 employees who participate in a 401(k) plan are allowed to designate part (or all) of their contributions to the plan as Roth 401(k) contributions as long as the plan has been amended to accept such contributions. Note, however, that qualified plans are not required to do this. Unlike an employee’s traditional 401(k) elective contributions, Roth 401(k) elective contributions are fully subject to tax in the year in which they are made (i.e., contributions are post-tax). However, the earnings on such contributions escape being taxed if they are not withdrawn from the 401(k) plan before the later of (a) when the account owner reaches age 59½, becomes disabled, or dies; or (b) five years after the Roth 401(k) account is first funded.

For 401(k) plans that have been amended to allow Roth contributions, the plan must track these contributions and their related earnings in an account that is separate from: (1) the employee’s regular 401(k) contributions, (2) any employer matching contributions, (3) any forfeitures allocated to the employee, and (4) the earnings thereon. Accordingly, all that will be in an employee’s Roth 401(k) account will be the employee’s own after-tax Roth contributions and the related earnings (any matching contributions made by an employer would be part of the employee’s regular 401(k) account). Unfortunately, there is currently no provision for converting existing regular 401(k) accounts into Roth 401(k) accounts. Keep in mind that this separate accounting requirement adds another layer of complexity to the qualified plan, and also increases the recordkeeping and compliance costs of the employer. Furthermore, and subject to a plan allowing it, employees may split their annual 401(k) contribution limit between regular (pretax) and Roth (post-tax) contributions, in any manner they choose, or they may make only regular or only Roth contributions.

Observation

In general, traditional 401(k) pretax contributions tend to make more sense for employees who expect their marginal tax bracket to fall in the future. Roth 401(k) post-tax contributions are more likely to be the right choice for employees who expect their marginal tax bracket to increase, or at least stay the same, in the future.

A significant advantage of Roth 401(k) accounts over Roth IRAs is that the annual contribution limit is higher for Roth 401(k) accounts ($15,000 for 2006, increased to $20,000 for individuals who will be at least 50 by the end of 2006) than for Roth IRAs ($4,000 for 2006, increased to $5,000 for individuals who will be at least 50 by the end of 2006). Also, there is no income phaseout limitation for making Roth 401(k) contributions (although the annual limits on employee contributions to 401(k) plans, including Roth 401(k) plans, apply, and the standard 401(k) nondiscrimination rules also apply, which can limit certain higher-income taxpayers’ ability to make contributions – just as the rules currently do for regular contributions). However, Roth 401(k) contributions are post-tax, so adjusted gross income is not reduced, which may cause the reduction of deductions or credits. As the saying goes, you may want to "crunch the numbers."

We have developed a comprehensive proprietary model that allows us to quantify the difference in value between traditional 401(k) and Roth 401(k) accounts. This model allows us to determine, for virtually any person, at any age, in any current (or retirement) federal tax bracket, and for any amount of annual 401(k) contributions, the projected difference in the two types of 401(k) accounts. Whether you are 25 and just getting started making 401(k) contributions, or 55 and contemplating making contributions for just a few years, our model can quantify the financial difference between the two alternatives. The difference may be much greater (or far smaller) than you envision, but having information on which to make an informed decision is the key.

The accompanying graphs illustrate the after-tax differences between making Roth 401(k) and traditional 401(k) contributions under three different scenarios.

The graphs are not intended to cover every possible pattern of contributions or distributions, changes in current or retirement marginal federal income tax rates, or changes in the rate of return on the amounts contributed, and they are not intended to provide legal or tax advice. They are intended to be used as a guide in illustrating the range of potential differences in the net values of Roth 401(k) and traditional 401(k) accounts.

As the graphs illustrate, in the first scenario the Roth 401(k) net value is significantly higher than the traditional 401(k) net value; in the second scenario the traditional 401(k) net value is significantly higher than the Roth 401(k) net value; and in the third scenario the two net values are not significantly different.

Since there is no crystal ball to look into to determine what will happen to federal income tax rates in the future, the most prudent approach is to view your alternatives using current federal law and to modify any decision you make based on future changes in the law.

We would be delighted to perform the Roth 401(k) vs. traditional 401(k) analysis for you. Feel free to contact us for an analysis specific to your own situation.

For more information, please contact Michael A. Gillen, director of the Duane Morris Tax Accounting Group.

As required by United States Treasury Regulations, you should be aware that this communication is not intended to be used, and it cannot be used, for the purpose of avoiding penalties under United States federal tax laws.

This newsletter is for general information and does not include full legal analysis of the matters presented. It should not be construed or relied upon as legal advice or legal opinion on any specific facts or circumstances. The invitation to contact the authors or attorneys in our firm is not a solicitation to provide professional services and should not be construed as a statement as to any availability to perform legal services in any jurisdiction in which such attorney is not permitted to practice.

Duane Morris is a registered service mark of Duane Morris LLP.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

 
In association with
Related Topics
 
Related Articles
 
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Mondaq Free Registration
Gain access to Mondaq global archive of over 375,000 articles covering 200 countries with a personalised News Alert and automatic login on this device.
Mondaq News Alert (some suggested topics and region)
Select Topics
Registration (please scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions

Mondaq.com (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of www.mondaq.com

To Use Mondaq.com you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these Terms or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.

Disclaimer

The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use of the Content or performance of Mondaq’s Services.

General

Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions