Roth IRAs have become popular retirement vehicles, but the low contribution limits and participant income limitations have prevented many people from taking advantage of them. The Economic Growth and Tax Relief Reconciliation Act of 2001 provided for designating Roth contributions within a qualified plan. Now many individuals previously excluded can take advantage of the tax-free growth of Roth contributions through a Roth 401(k).
The Roth 401(k) is a feature that can be added to a new or existing company-sponsored defined-contribution pension plan, including traditional 401(k)s, safe-harbor 401(k)s, and 403(b) tax-sheltered annuities. Employees may elect to designate a portion or all of their elective contributions as Roth contributions. Contributions are included in gross income at the time the employee would have received the contribution amounts in cash if the employee had not made the cash or deferred election. Earnings on the account accumulate tax-free, and distributions, if they are qualified, are tax-free.
A qualified distribution is one that occurs at least five years after the year of the participant’s first designated Roth contribution and is made on or after the participant reaches age 591/2, because of the participant’s disability, or on or after the participant’s death.
An individual may make both traditional pretax and Roth-designated contributions in a plan year. In 2008, an individual has an aggregate elective contribution limit of $15,500 for all designated Roth contributions and traditional pretax contributions (with an additional $5,000 if the participant is age 50 or over). The maximum employee and employer annual contribution is the lesser of $46,000 or 100% of compensation.
Employers may match Roth contributions, but these contributions do not get added to the Roth account. Rather, the employer match will be with pretax funds that must be kept in a separate account. While the employee’s Roth contributions may be withdrawn tax-free, the employer-matched funds will be treated as ordinary income at withdrawal.
Because the 401(k) plan will allow for pretax contributions that are includible in income when distributed (traditional and employer-matched contributions) and contributions made with after-tax income that will be distributed tax-free (Roth contributions), there must be separate accounts and separate recordkeeping for the different types of contributions.
While a traditional IRA may be converted into a Roth IRA, there is no provision for converting a pretax elective contribution account under a 401(k) to a designated Roth account. A direct rollover of a distribution from a Roth 401(k) may only be made to another Roth elective deferral account, such as another Roth 401(k) or a Roth IRA.
Roth 401(k)s are most appropriate for individuals who would like to contribute to a Roth IRA for tax-free growth but are unable to do so because of income limitations or who would like to contribute more than they currently can under the IRA rules. In general, younger individuals saving for retirement and those who expect their tax bracket to increase would benefit greatly from making Roth designations.
For a detailed discussion of the issues in this area, see “Ten Things to Know About the Roth 401(k),” by Kristy Hasseltine, in the September 2008 issue of The Tax Adviser.
—Alistair M. Nevius, editor-in-chief
The Tax Adviser
Also look for articles on the following topics in the September 2008 issue of The Tax Adviser:
- An analysis of the new preparer penalty proposed regulations.
- A discussion of developments in estate planning.
- An update on individual taxation.
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