First came the 401(k), which, in just a quarter-century, became the most popular retirement plan of all time. Then, Roth IRAs were born in 1998, allowing millions of Americans to build up retirement nest eggs that they could tap into tax-free.
What would happen if you combined the two?
You're about to find out.
Alert: The IRS just proposed regulations that would pave the way for a major new retirement plan opportunity. Beginning next January, 401(k) participants will be able to designate all or part of their contributions as Roth IRA contributions. (IRS proposed regulation REG-152354-04)
So-called Roth 401(k)s were actually authorized by a 2001 tax law, but taxpayers weren't allowed to include them in their retirement plans until next January.
How Roth 401(k)s will work. As with your regular 401(k) plan, participants could choose to defer salary to an account where the funds accumulate tax-free. But unlike traditional 401(k) contributions, which come from pretax dollars, Roth 401(k) contributions would come from after-tax contributions.
Here's the big difference: While money pulled from regular 401(k)s is taxed as ordinary income, withdrawals from Roth 401(k) accounts will be 100 percent tax-free, as long as they're taken at least five years after the first contribution and after age 59 1/2.
Bottom line: Generally, any Roth-type investment is preferable if your tax rate will remain the same or be higher in retirement. We'll provide more advice and details on Roth 401(k)s as the year rolls on.
Employers will need to amend their current qualified plans to allow for Roth 401(k)s. Generally, most of the same nondiscrimination requirements and vesting rules for 401(k)s also apply to this hybrid plan.
The IRS rules outline three basic requirements for your plan:
1. Participant allocates money to Roth. The participant must make an irrevocable Roth contribution designation at the time of the deferral.
2. Contribution treated as income. Employers must treat the contributions as taxable compensation, just as if the participant had received cash.
3. Keep funds separate. Employers must maintain the Roth contributions in separate accounts.
More good news: You'll face no restrictions for high earnings. That means you'll be able to contribute to a Roth 401(k) account regardless of whether you earn $10,000 a year or $10 million. (In comparison, joint filers with income above $160,000 can't contribute to a Roth IRA.)
Online resources: Read the IRS proposed rules on the new Roth 401(k) at www.roth401k.com/proposedregs.htm. To read recently published articles on the topic of Roth 401(k)s, go to www.roth401k.com.