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Consider diversifying investment options with Roth 401(k)s

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in Compensation and Benefits,Human Resources

It may be time to talk to your fund administrator about adding a new feature to your organization’s portfolio of retirement benefits: the option for employees to transfer 401(k) funds into a Roth 401(k).

It’s a little-noticed tax break that was tucked into the “fiscal cliff” tax law—the American Taxpayer Relief Act of 2012.

Moving retirement savings from a traditional 401(k) to a Roth 401(k) could provide a big boost, especially for upper-income savers.

And setting up a Roth 401(k) retirement option can be particularly advantageous for workers under 30, who will probably be taxed at progressively higher rates as they continue working.

Your retirement fund provider can help set up a Roth 401(k) option for your employees. So far, the funds have proven popular in large firms, but they’re gaining traction among smaller employers, too.

A tax-free retirement?

Roth 401(k)s offer attractive tax incentives.

How attractive? Try tax-free.

Funds distributed from a Roth 401(k) account when an employee retires will be completely exempt from federal income tax.

Here’s the whole story: As with a regular 401(k) plan, contributions to a Roth 401(k) account grow on a tax-deferred basis. However, unlike a regular 401(k), elective deferrals aren’t made with pretax dollars. The amounts contributed to the plan are subject to current tax.

With a Roth 401(k) plan, the benefits come on the back end: Qualified distributions are 100% federal-income tax free and usually state-income-tax-free, too.

In comparison, distributions from a regular 401(k) are taxable at ordinary income rates, now reaching as high as 39.6% under current rules.

Note: The contribution limits for traditional 401(k) and Roth 401(k) plans are the same. For 2013, employees can contribute up to $17,500 to either type of account ($23,000 if they’re 50 or older).

How transfers work

Roth 401(k)s may be most attractive to mid-career employees. If you decide to offer a Roth 401(k) option, those workers will likely look to convert funds from your existing 401(k) plan.

It doesn’t have to be an all-or-nothing proposition. For instance, employees can keep some of their funds in a regular 401(k) account. Alternatively, they might move all the funds to a Roth 401(k) account over several years, thereby reducing the overall tax bite.

Employees must pay tax in the year they convert, but it could be well worth it if they expect to be in a higher tax bracket when they retire.

Tax: $56,000 vs. $350,000

Here’s an example of the tax advantage offered by a Roth 401(k):

Suppose an employee, Jane, is 40 years old, in the 25% tax bracket, with $200,000 in a regular 401(k). For simplicity, let’s say she converts the entire $200,000 to a Roth 401(k) in 2013 and pays an effective tax rate of 28%. (The actual amount will depend on all the other variables that affect her taxable income level.)

Thus, Jane pays a tax of $56,000 on the conversion.

Assume that the Roth 401(k) grows to $1 million by the time Jane is ready to retire in her 60s. No matter how much she withdraws from the Roth 401(k) during retirement, she’ll pay zero federal income tax on the distributions.

Note: Funds must remain in a Roth 401(k) for five years—and typically after age 59½—before they can be pulled out tax-free.

Now compare that to the outcome if Jane accumulates $1 million in a regular 401(k) and ends up in the 35% tax bracket in retirement. In the unlikely event she pulls out the entire amount in lifetime distributions, Jane would pay a whopping $350,000 in federal income tax—and maybe state income tax, too.

A more likely scenario: Jane might withdraw half and pay tax of $175,000—still $119,000 more than the tax currently owed on the conversion. Also, consider the possibility that tax rates will be even higher by the time she is ready to retire.

On the flip side, switching to a Roth 401(k) may not make sense for employees who will be retiring soon and expect to be in a lower tax bracket in the future.

More info: For official IRS information on Roth 401(k)s, see “Retirement Plans FAQs on Designated Roth Accounts.”

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