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The New Roth 401(k)
The average employee doesn't make the full contribution allowed by law (the law allows up to $20,000 a year but the average employee who contributes to these plans and who makes the average income of $45,000 only puts away 7% of their income for retirement). This amounts to about $3,000 per year saved per employee.
If that contribution were made to a Roth 401(k), they would only need to make a $2250 contribution to beat the after-tax implications of a regular 401(k). But most folks don't bother with the math, which in this case is good. So, if the employee were to make a $3,000 contribution to a Roth, they would be actually saving an additional $750 over those with a traditional 401(k). Another hidden plus for these savers requires companies who match to make those matching contributions to a traditional 401(k) plan. This gives the employee an account that could pay taxes on your gains in your Roth.
Just to clarify the differences further: Roth contributions are made after taxes and the gains from the account are taxed at withdrawal for non-qualified distributions and are tax-free and penalty free for qualified distributions.
Qualified distributions are withdrawals made at age 59 1/2, are used for building a home or rebuilding a current one for a qualified family member (the IRA owner's spouse, a child of the IRA/401(k) owner and/or of the IRA/401(k) owner's spouse, a grandchild of the IRA owner and/or of his or her spouse, a parent or other ancestor of the IRA/401(k) owner and/or of his or her spouse with a $10,000 per lifetime limit (if both spouses own Roth plans, they both can each withdraw the full amount allowable), considered as part of an inheritance, or used for by the IRA/401(k) owner upon disability.
The participant must hold the Roth IRA/401(k) for five years after the initial contribution. Early withdrawal penalties apply if disbursement takes place prior to that time period.
However, it is not as simple as that. Many folks have considered a conversion from a traditional plan to Roth. This adds another layer of tax considerations.
Income taxes, which were deferred in the traditional plan are usually paid so any disbursement would be tax-free. Penalties may apply if the owner chooses to receive funds before 59 1/2 years of age or before the five-year period expires. Adding a traditional plan to an existing Roth although allows the penalty to be waived for the new funds provided the Roth meets the qualified distribution rules.
Non-qualified distributions are any distributions that do not meet the requirements for a qualified distribution. The distributions are often subject to tax and penalties
It is important to take into consideration the IRS treatment of such plans. They use something referred to as an "ordering rule" to determine taxes.
Once distributions begin, the IRS considers the following when making taxable considerations. First distribution would come from regular Roth IRA/401(k) participant contributions followed by any funds in the account from taxable Traditional IRA/401(k) conversions. next in the order rule is any funds from a nontaxable Traditional IRA/401(k) conversion followed lastly by earnings on all Roth IRA/401(k) assets.
Traditional 401(k) plans have contributions made before taxes with the tax bill paid when the employee retires and begins taking distributions.
Editor's note: Thanks to Jodi VK for pointing out our failure to fully explain qualified and non-qualified distributions. This article was revised and updated on 4.19.07 to reflect those corrections.
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