This article will explore the two types of Roth IRA's, the
Roth IRA and the Roth 401(k). I will address the
similarities and the substantial differences in the two.
The Roth 401(k) plans started in 2006 with the Economic
Growth and Tax Relief Reconciliation Act of 2001. They are
often referred to as hybrids, meaning they are a cross
between the traditional 401(k) plan and the Roth IRA. A
Roth 401(k) is an option under the traditional 401(k) plan.
So a plan cannot exist with only a Roth 401(k), plans must
offer both pre- and after tax contribution options. An
after tax contribution is made by designating a portion of
your compensation as a Roth 401(k) contribution. You must
know that this designation is irrevocable, you will not be
able to reassign a Roth 401(k) contribution to have it
later treated as a conventional pre-tax contribution.
Roth 401(k) contributions will not reduce your W-2 income.
The amount of the contribution will be included in your
income and be reported on your W-2 as taxable wages and
compensation. The advantage is that earnings can then build
up tax free.
Roth 401(k)s are similar to traditional 401(k)s in a number
of ways. Both traditional Roth IRA's and the Roth 401(k)
have the same contribution limits. Fro 2007, up to $15,500
can be designated as a Roth 401(k) contribution, or if you
are 50 or older you can designate up to $20,500 by the end
of 2007. The contribution limits are adjusted annually for
inflation. You may designate all or part of your
contribution to the Roth 401(k). You must decide on how to
split these contributions by looking at your tax situation
and the advantages of each plan. You should consider the
current and the future tax implications of each plan and
weigh the current tax cost against the potential tax free
income in the future.
Employers are allowed to make contributions , but the
actual contributions can only be allocated to the
traditional 401(k) accounts. No portion of your employer
match may be allocated to the Roth 401(k). Also, funds must
be held separately for regular and Roth 401(k)
contributions. Investment earnings and charges must be
allocated appropriately to each type of account. If you
have any plan forfeitures, they can only be allocated to
the conventional 401(k); they cannot be allocated to the
Roth 401(k).You will have to keep track of each.
You must designate a contribution to the Roth 401(k) before
a contribution can be made. Also, under the terms of the
plan you must be able to make designations annually.
Allocations to each type of account are non-forfeitable.
This means that if you leave a job, you have the option to
roll over the Roth 401(k) to an account with a new employer
or to roll the funds over to a Roth IRA. A rollover to
another Roth 401(k) can be made only via a direct transfer
to a new account. The five-year period, discussed more
fully below, will carry over to the new Roth 401(k).
If funds should be distributed to you directly, you can be
roll over the funds within 60 days to a Roth IRA. They
cannot be rolled over to a Roth 401(k) at a new employer
because they were distributed directly to you rather than
transferred directly to the new Roth 401(k). The five-year
period does not carry over from a Roth 401(k) to a Roth
IRA; a new five-year period must commence following a
rollover to a Roth IRA. Also, once funds have been rolled
into a Roth IRA, they cannot be rolled to a Roth 401(k).
Roth 401(k) contributions differ from traditional 401(k)
contributions in one obvious way. Roths are made with
after-tax dollars, while traditional 401(k) contributions
are currently excluded from income. What this means to you
is traditional 401(k)s will lower current taxes, while
Roths will have no immediate impact on them. However, the
earnings on Roth 401(k)s can become fully tax free. Both
contributions and earnings in traditional 401(k)s remain
fully taxable when distributed.
Roth 401(k)s are similar to Roth IRAs because both are
funded with after-tax contributions. There isn't an
immediate tax break for putting money into the plan. Roth
401(k)s are also similar to Roth IRAs in the way in which
qualified distributions are treated. As with a Roth IRA,
funds must be held in a Roth 401(k) for at least five
years, then be distributed after age 59-1/2, or on account
of disability or death. The first time home buying
distribution option for the Roth IRA does not apply to the
Roth 401(k).
Roth 401(k)s are different from Roth IRAs in several
important ways. These are as follows;
1) Funds from a regular 401(k) cannot be converted to a
Roth 401(k), while funds in a traditional IRA can be
converted to a Roth IRA. Currently there are income limits
on eligibility to convert. Starting in 2010, the income
limits are dropped, so you eligible to convert at that time.
2) There is no income limitation on funding a Roth 401(k)
as there is for Roth IRAs. In 2007, single taxpayers with
modified AGI over $114,000 and joint filers with MAGI over
$166,000 are barred from contributing anything to a Roth
IRA. Under these circumstances, Roth 401(k)s have the
obvious advantage over Roth IRAs.
3) There are required lifetime distributions from Roth
401(k)s; there are no such requirements for Roth IRAs,
making Roth IRAs better. This generally means that
withdrawals from a Roth 401(k) must commence at age 70-1/2.
If you are still employed at the company maintaining the
plan, the plan can allow distributions to commence after
retirement if later than age 70-1/2.
4) Contribution limits are substantially higher for Roth
401(k)s than for Roth IRAs. As mentioned earlier, the top
contribution to a Roth 401(k) in 2007 is $15,500, or
$20,500 for those age 50 or older by year end. For Roth
IRAs, the contribution limit for 2007 is $4,000, or $5,000
for those 50 or older by year end. In this respect, Roth
401(k)s are better than Roth IRAs.
5) Early distributions which are distributions before the
end of the five-year period, are treated differently. For
Roth IRAs, an early distribution is treated first as
relating to nontaxable after-tax contributions. If the
distribution exceeds these contributions, the excess
becomes taxable. Earnings are considered to be withdrawn
last. So if a distribution does not exceed contributions to
a Roth IRA, there is no current tax.For Roth 401(k)s,
non-qualified distributions are included in gross income to
the extent allocable to income on the contract, and
excluded from gross income to the extent allocable to
investment in the contract. The amount of a distribution
allocated to investment in the contract is determined by
applying to the distribution the ratio of the investment in
the contract to the designated Roth account balance. If you
under age 59-1/2 when the distributions are taken, there is
a 10% early distribution penalty, unless an exception to
the penalty applies.
So when would it be advisable to use a Roth 401(k)? Here
are some factors to consider.
1) If you are younger with a long time until retirement,
you may wish to opt for future tax-free income by
sacrificing current income deferral. If so, you should
choose the Roth over the traditional 401(k). There will be
many years in which to build up a sizable retirement fund
that produces tax-free income.
2) If you are planning to leave retirement funds to
charity, you probably will want to opt for the traditional
401(k). This will give you current tax deferral and no
future tax cost. For example, an estate can claim a
charitable deduction for funds left to charity.
3) If you are currently in a lower tax bracket, you will
not save substantial taxes by opting for current income
deferral, and may prefer making Roth 401(k) contributions
to the extent possible. In this way, future withdrawals
will be tax free when you probably will be in a a higher
tax bracket.
This article may not be complete and you should consult an
expert about your individual tax situation. However, I have
attempted to provide enough information to help educate
yourself on the basics. I hope you have found this
information helpful.
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Steve Jackson is a professional income tax preparer with
over twenty years experience, helping clients with their
individual tax situations. Steve offers tax services and if
you file online, he can be here to help you with your tax
situation, and will provide you with free updates during
the year. Contact Steve at http://www.jjackson328.com
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