Money Management - July 2005

Roth 401(k): A New Solution

To Benefit Professionals

by Emmet Scott

Planning for retirement can be both exciting and scary as one investigates investment, insurance and saving alternatives. Popular options in the past have revolved around the Traditional IRA, Roth IRA, 401(k)s, SEP IRAs and Simple IRAs. Each option had its own limitations and benefits.

In 2006 a new option called the Roth 401(k) will be entering the retirement benefits stage. The Roth 401(k) takes the investment limits of the 401(k) plan and adds the tax-saving benefits of a Roth IRA. Roth 401(k)s are poised to become a powerful retirement solution for professionals at any income level who are looking for an alternative to existing plans.

Since the Taxpayer Relief Act of 1997, Roth IRAs have been a popular means for taxpayers below certain income thresholds ($110,000 for single individuals, $160,000 for married individuals) to put aside after-tax dollars in their IRAs. However, because of these income limitations, a majority of working professionals have not been able to establish Roth IRA accounts.

In 2001, Congress enacted the Economic Growth and Tax Relief Reconciliation Act (EGTRRA). EGTRRA brought a sweeping set of changes to the rules governing pension plans, 401(k) plans and other defined contribution plans. These changes will make it possible for employers to establish Roth 401(k) accounts beginning in 2006, benefiting employees at many income levels.

Although some employees are currently eligible to contribute to Roth IRAs, the maximum amount these employees can contribute is very limited ($4,000 in 2005, or $4,500 for persons age 50 or over). The new Roth 401(k)s will allow all employees to save up to $15,000 per year. There is no future income tax liability on the earnings if the distribution meets the requirements for a "qualified distribution."

Roth 401(k) contributions have the added benefit over the Roth IRA of being matched by the employer. Matching is done pre-tax, but is taxable at distribution. A participant may roll over his or her Roth 401(k) account contributions to a Roth IRA.

The new plan is positioned to allow a retiree who has been contributing to a Roth 401(k) with matching funds from his or her employer to have both tax-free and taxable retirement funds by following the distribution rules.

Because a participant’s Roth 401(k) account will be treated as an elective deferral, it will only be eligible for distribution on a participant’s termination of employment, death, disability, attainment of age 59.5 (if permitted under the terms of the plan) or hardship. However, a participant’s reaching one of these distribution events will not necessarily ensure tax-free treatment of distributions of his or her Roth 401(k) account. In order to be treated as a tax-free distribution, a distribution from a Roth 401(k) account must be a "qualified distribution." In order to be treated as a "qualified distribution," the distribution must not only meet these guidelines, but it also cannot be made within five years of the first Roth 401(k) contribution to the plan or predecessor Roth 401(k) plan. Unlike a Roth IRA, a distribution from a Roth 401(k) to finance a first home purchase will not be treated as a "qualified distribution."

For more information on the new Roth 401 (k) plan visit www.irs.gov.

Emmet Scott
Emmet Scott is a financial coach for Capstone Capital, a Henderson-based financial service firm.