ROTH:  A NEW 401(k) OPTION


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

​​​BY
David J. Schiller, J.D.

          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.

            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.  (See the next page to find out what’s involved in permitting Roth 401(k) contributions.)

            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 pre-tax 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.

WHAT YOU NEED TO KNOW ABOUT DISTRIBUTIONS:

            The same distribution restrictions apply to Roth contributions as to traditional pre-tax contributions.  In general, a distribution may only be made upon death, disability or termination of employment; when the participant reaches age 59-1/2 or upon a hardship (such as to prevent eviction or to pay for uninsured medical expenses).  It’s up to the employer whether a plan will permit distributions for any or all of these events.

            Unlike contributions to a Roth IRA, Roth contributions to a 401(k) plan are subject to the rules that apply to 401(k) plans, so they may be used to make participant loans and to purchase life insurance for the participant.  Again, the employer has the option to allow these benefits—or not.

            When you withdraw money from your 401(k), the principal and earnings on the Roth contributions aren’t taxable as long as the distribution is “qualified” which means that you’re age 59-1/2 or over, you’re disabled, or they’re being paid because you’ve died.  Also, to be qualified, five years must have passed since your first Roth contribution to a 401(k) plan.

            Earnings on the Roth contributions will be taxable as ordinary income and you may owe a 10 percent penalty if you receive a distribution that isn’t “qualified” and you fail to properly roll it over.   Roth 401(k) distributions may only be rolled over to a Roth IRA or to another 401(k) plan that will accept the rollover.

            Roth 401(k) plan participants must generally begin taking distributions from the plan no later than age 70-1/2, unless they’ve rolled the Roth 401(k) proceeds into a Roth IRA, which doesn’t have a minimum distribution requirement. 
 

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David Schiller  is a Philadelphia attorney who specializes in taxes and pension planning for physicians.
PUBLISHED IN:  MEDICAL ECONOMICS/NOVEMBER 4, 2005