ROTH 401(k): Background and Strategies Part 1

Anybody that follows financial news programs, websites or publications undoubtedly has heard the terms ROTH and 401(k) in the sentence the last few years.  Hopefully we can shed some light on what can be a confusing topic.  Part 1 will discuss the background of the 401(k) and Part 2 will focus on strategies when comparing ROTH and pre-tax contributions.

What is a ROTH 401(k)?

Technically a ROTH 401(k) Plan is not a stand-alone retirement plan.  Starting in 2006 provisions set forth in EGTRRA (Economic Growth and Tax Relief Reconciliation Act of 2001) was made permanent.  This allowed existing and future 401(k) plans to allow employees to designate part or all of their salary deferrals as ROTH contributions. 

ROTH contributions are made after-tax (you don’t get a tax deduction), grow tax-deferred, and can be distributed tax-free at retirement.  By comparison, traditional 401(k) contributions are made on a pre-tax basis, grow tax-deferred, and are taxed at an ordinary income rate when withdrawn during retirement.

Are ROTH contributions available in all 401(k) Plans?

Although ROTH contributions are allowed, it isn’t mandatory that your 401(k) plan allows them.  You plan has to adopt this feature.  A recent survey conducted by Mercer shows that only 45% of plans currently allow for ROTH contributions.  Keep in mind that this study was mostly made up of large company employers (over 1,000 employees) that typically adopt new features sooner than their small company counterparts.

Plan sponsors typically respond to employee demand when adding plan features.  The more demand there is the greater the likelihood that a feature like ROTH contributions is added.  You should ask your plan sponsor/administrator if the plan allows for ROTH contributions, and if not to add this feature.

What about other types of plans?

Employees of state and local governments the ability to allow for ROTH contributions in their deferred compensation plans (a.k.a. 457) was made possible during 2010 in the passage of the Small Business Lending Fund Act.

In our next blog post Part 2 will discuss things to take into consideration when implementing ROTH dollars into your retirement portfolio as well as certain strategies.

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