The Roth 401(k) plan, as the name suggests, couples the features and benefits of a traditional 401(k) plan and a Roth IRA to provide employees with a good retirement savings plan. To understand Roth 401(k) better, one needs to have some basic knowledge of traditional 401(k) and Roth IRA.
Traditional 401(k)
Traditional 401(k) is a retirement savings plan where an employee makes tax deferred contributions to their 401(k) account. The contributions that an employee makes are tax deferred,
which means that they are made to the account before the employee’s pay is taxed. The funds from this account are put into investment vehicles where they grow tax deferred as well. Another benefit of the traditional 401(k) is that an employer may also choose to ‘match’ the employee’s contribution, adding more funds for investments.
Roth IRA
Roth IRA is a simple retirement plan where the contributions made to the account are after-tax. This means that the amount put into the account is already taxed. The amount from the contributions is then invested into funds like stocks, mutual funds etc where they grow tax free. When an employee makes a qualified withdrawal from the account the amount is not taxable. However, the contribution limits for the Roth IRA are small. In 2010, an employee can make only up to $5,000 contributions to the account annually ($6,000 if the employee is above the age of 50).
Roth 401(k)
Roth 401(k) plan enables the employee to make contributions to their Roth 401(k) account where the contributions are made of after-tax dollars. However the contributions and the investments made from such contributions in the Roth 401(k) account grow tax free. Also, qualified withdrawals made from the Roth 401(k) account are not taxable since tax is already deducted upon contribution.
This is considered as a great advantage by many who think that tax rates and brackets are only going to go up in the future. If such a scenario does occur, Roth 401(k) plans would be more beneficial than traditional 401(k) plans as one won’t pay any taxes on qualified withdrawals made from a Roth 401(k) account. Whereas qualified withdrawals from a traditional 401(k) account would be subject to more taxes than when the contributions were made.
The annual contribution limits of Roth 401(k) are the same as traditional 401(k). However it should be noted that these are not separate limits for each. An employee can cumulatively contribute up to $16,500 to their 401(k) and Roth 401(k) account if they are below the age of 50 and can contribute cumulatively up to $22,000 if they are above the age of 50. For example, if an employee made pre-tax contributions of $10,000 to their traditional 401(k) account, they can make only up to $6,500 of after-tax contributions to their Roth 401(k) or vice versa. Even with this, the contribution limits for Roth 401(k) are higher than Roth IRA. Hence these plans can be beneficial to high earning employees whose contributions are restricted in a Roth IRA.
Given the rate at which Roth 401(k) plans are growing popular, they have got a new lease. The plans were supposed to be phased out in 2010; however, with a new law that was passed in 2006, Roth 401(k) plans are now available permanently.
