“Be not the first by whom the new are tried, nor yet the last to lay the old aside!”

– Alexander Pope

A new tax-free retirement plan became available on January 1 of this year. On that date and at any time thereafter – but before December 31, 2010 when the provision enacting the Roth 401(k) expires – employers who offer traditional 401(k) retirement plans are permitted to expand those retirement plans to include Roth 401(k)s. When Congress first created the Roth 401(k) back in 2001, very few people noticed or even cared about it. Investors and financial professionals alike were far more excited about the other, more interesting, provisions of the 2001 tax act. Because of their potential application, it is now time for everyone to sit up and take notice of these retirement plans.

The new Roth 401(k) is a hybrid retirement plan that possesses the characteristics of both a traditional 401(k) and a Roth Individual Retirement Account (“IRA”). It allows employees who participate to treat all or part of their contribution amount – the amount deducted from their paychecks – as a Roth contribution. This means it will receive the same tax treatment as that of a Roth IRA. This also means that the amount treated as a Roth contribution will no longer result in a federal income tax deduction like contributions to a traditional 401(k). However, the growth on the contribution as well as “qualified distributions” are not subject to income tax the way growth or distributions from a traditional 401(k) are. A qualified distribution is one that is made after a participant has reached age 59 ½, has become disabled or has died. The funds withdrawn in the distribution must also have been in the Roth 401(k) plan for more than 5 years.

Roth 401(k)s and Roth IRAs are not identical. The biggest difference is that the Roth 401(k) is available to a much larger pool of people than the Roth IRA. Among the people who stand to benefit most from Roth 401(k)s are affluent Americans, who are otherwise excluded from making contributions to a Roth IRA. In 2006, Roth IRA contributions are only available to married couples who have adjusted gross income of $160,000 or less and single individuals with adjusted gross income of $110,000 or less. These adjusted gross income limits do not apply to a Roth 401(k). Thus, those people who might otherwise be unable to contribute to a Roth IRA because of their income levels, are now able to participate in a Roth 401(k), if such a plan is offered by their employer. Even if you qualify to participate in both a Roth 401(k) and a Roth IRA, the Roth 401(k) allows you to contribute more into the plan than the Roth IRA. The Roth 401(k) allows you to contribute $15,000 per year ($20,000 if you are 50 or older), while the maximum contribution to a Roth IRA is $4,000 ($5,000 if you are 50 or older). To help clarify these points, let’s look at an example.

EXAMPLE

Mark, a 45 year-old employee, is a participant in his company’s traditional 401(k) plan. Because he and his wife make more than $160,000 per year, he has never been eligible to contribute to a Roth IRA. Instead, he has regularly contributed the maximum allowable contribution to his traditional 401(k) since he started working and planned to do this for the rest of his working career.

On January 1, 2006, his employer adopted a Roth 401(k) plan to go along with the company’s traditional 401(k) plan that had been in place for many years. As a result, Mark now has a choice to make. Mark can do one of three things: (i) continue making his regular tax-deductible 401(k) contribution; (ii) elect to make his contribution to the new Roth 401(k); or (iii) split his contribution between the traditional tax-deductible 401(k) and the new Roth 401(k).

In making this decision, Mark must realize that there is a fundamental difference in the way his traditional 401(k) and the Roth 401(k) are taxed. With the traditional 401(k), all of Mark’s contributions to the plan are tax deductible. Any appreciation in the account is tax-free. When Mark retires and begins taking distributions from the 401(k), the distributions are taxable income to Mark at his then existing income tax rate.

On the other hand, Mark’s contributions to his Roth 401(k) are not tax deductible. Like the traditional 401(k), any appreciation in the account is tax-free. When Mark retires and begins taking distributions from his Roth 401(k), those distributions are tax-free as long as they are qualified distributions. Instead of taking distributions from his Roth 401(k) upon retirement, Mark could roll the money from his Roth 401(k) into a Roth IRA. Doing so would give Mark an advantage over those individuals with traditional IRAs.

Most individuals with traditional IRAs have to begin taking distributions from the IRA by April 1 of the year after the year in which they reach age 70½. With a Roth IRA, however, an individual is not required to take distributions at any time. This permits an individual who holds Roth IRA assets and does not need the money to let it grow income tax free for their lifetime. Upon the individual’s death, his or her Roth IRA will pass to his or her heirs income tax-free. The heirs can then extend the life of the tax-free growth of the Roth IRA over their lifetimes by only withdrawing the minimum amount required by law each year.

Generally speaking, it is better to contribute to a Roth 401(k) than a traditional 401(k) if you are going to be in a higher income tax bracket in retirement than the one you are presently in or will be in during your working career. In addition, contributions to a Roth 401(k) can be beneficial for someone who has substantial retirement assets from other sources. In that case, he or she will not need to draw on his or her Roth assets when he or she reaches the age of 70½ and can let them grow tax-free during their lifetime.

In summary, whether you should invest in the new Roth 401(k) or a traditional 401(k) is complicated and confusing. Before making such a decision, one must look at their present and future financial condition. We can be of assistance. Please do not hesitate to contact us if you need help determining what is best for your particular circumstances.