Money Management - November 2006

The Roth 401(k) Plan

Can It Permanently Improve Your Future?

by Jason Thomas

In 2006, two things happened to strengthen the ability of investors to shelter income in a tax-deferred pension plan. The first was the creation of the Roth Section 401(k) plan on January 1, 2006. The second occurred on August 17, 2006, when it became a permanent fixture of the available tax-deferred saving plan options. Originally, the Roth 401(k) plan was set to expire after 2010, but the Pension Protection Act of 2006 eliminated the expiration.           

The Roth 401(k) plan entitles the participant to contribute $15,000 per year of post-tax earnings to a tax-deferred savings plan. Contributions can be withdrawn tax-free after the age of 59 1/2. If the participant is over the age of 49, an additional $5,000 can be contributed annually to the plan. The traditional Roth IRA maximum contribution is $4,000, with a $1,000 catch-up contribution for older workers.            

The benefit of the Roth-type plans is that even the tax-deferred earnings accumulated over the years by the plan will never be subject to income taxes if managed correctly. Put another way, your retirement nest egg could never be reduced by income taxes, meaning more disposable income for the lifestyle you desire in your retirement.           

Since the original Roth Section 401(k) plan was set to expire after 2010, many employers were reluctant to establish the Roth as part of their benefit package. Now that the provision has become permanent, employers are more likely to implement the Roth feature to their existing Section 401(k) plan.            

The combination of having a traditional Section 401(k) plan with a Roth Section 401(k) does require the employer to maintain separate accounts for the employee. Funds of the Roth cannot be commingled with funds of the traditional 401(k) plan – a requirement that will cause additional administrative expense. However, the extra costs now appear justified, because the Roth feature is now permanent.            

The features of the Roth 401(k) can increase tax-deferred compounding of retirement investments. Savings under the traditional plan, combined with the Roth, could reduce risks because future tax brackets are unknown. If tax brackets go up, and Roth investments were taxed at a lower rate when they were originally contributed, then money is made by simply paying the tax early.           

Combine that with the non-taxability of the earnings on the Roth assets over time, and a financial hedge is created to defend against the risk of inflation and adjusted rising tax brackets. Further still, if a traditional 401(k) plan is utilized in conjunction with the Roth, current income taxes could be saved. The key is finding the right balance to getting the most effective tax-deferred savings portfolio with minimal risk.           

Rules for Roth 401(k)s have to be followed to make them worthwhile. For example, once funds are contributed, participants have to hold the account for five years in order to pull out funds tax-free, and be over 59 1/2 when they do so. In addition, the funds cannot be withdrawn penalty-free for the purchase of a first residence or qualified educational expenses, which a traditional Roth IRA allows. With any savings plan, the aspects of the plan need to be fully researched to make sure the advantages outweigh the disadvantages.           

All in all, the Roth Section 401(k) plan adds up to be a powerful savings plan. The benefits of the plan are too enticing to ignore for older, as well as younger, workers. It only makes sense to take advantage of the Roth 401(k) option if it creates more retirement savings in the long run.       

Jason Thomas
Jason Thomas is the tax manager for Fair, Anderson and Langerman, a Las Vegas-based CPA and business consulting firm.