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    Roth: A new 401(k) option

    Starting in 2006, you'll be eligible for this great benefit, which lets earnings grow tax-free.


    Do you offer a 401(k) plan in your practice, or do you participate in one where you work? Then you're familiar with the benefits of these plans. Participants contribute a portion of their income through salary deferral. So contributions are made on a pre-tax basis, which means they're excluded from taxable income. But when you withdraw money from the plan, it's taxed at ordinary income rates.

    Power Points
    Starting next year, you may be able to avoid this tax pitfall. Beginning in 2006, 401(k) plans (and 403(b) plans sponsored by tax-exempt organizations) can allow employees to make Roth contributions to their plans. You've probably heard of the Roth IRA, although there's a good chance you haven't been able to contribute to one because your income is too high. Well, Roth 401(k) contributions work by a whole different rulebook—one that doesn't prohibit people from participating because they earn too much.

    Because Roth 401(k) contributions are made with after-tax compensation, there's generally no tax due when you withdraw your contributions and earnings from the plan. So the earnings end up being tax-free, rather than simply tax-deferred as they are with traditional 401(k)s. (However, making Roth after-tax contributions won't reduce your tax bill for the year you made the contribution as traditional 401(k) contributions will.)

    You might be interested in adding Roth contributions to your 401(k) plan either for yourself, or as something to offer your staff members if you're in a small group practice.

    Interested? Here's what you need to know.

    Contribution limits and eligibility

    Beginning next year, Roth contributions to a 401(k) plan will have the same limit as traditional 401(k) contributions: $15,000 (plus a catch-up contribution of $5,000 for people 50 and over). After 2006, these contribution amounts will be indexed for inflation in $500 increments. And income limits don't apply. You can make Roth contributions to a 401(k) plan no matter how much you earn. (These contributions won't affect your ability to contribute to a traditional Roth IRA also, if you're eligible.)

    But understand that the $15,000 contribution is the combined limit for all salary deferral contributions to a 401(k) plan. You can't contribute $15,000 in traditional pre-tax contributions plus another $15,000 in Roth contributions. You could, though, contribute $10,000 in pretax contributions and $5,000 in Roth contributions. The same applies to catch-up contributions for participants age 50 and over. You can make a $5,000 Roth catch-up contribution or $5,000 in additional pre-tax contributions or your catch-up can be a combination of both, but your total catch-up contribution can't be more than $5,000.

    Is one type of contribution better than the other? There's no simple answer to this question, although the higher your earnings, the more attractive a Roth becomes. But, ultimately, whether you'll be better off making Roth contributions rather than traditional 401(k) contributions depends on your age, your financial circumstances, your tax bracket, and whether and when you'll need to access the account.

    The answer also depends on what you expect your investments to earn, as well as the tax rate you anticipate when the funds are withdrawn. For example, if you expect tax rates to be higher when you withdraw the money (because of changes in the law, fewer deductions, or higher income), then you may be better off making Roth contributions.


    David J. Schiller, JD
    The author is a Norristown, PA tax and estate-planning specialist, and an editorial consultant to this magazine.

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