Know the Roth 401(k) Rules—Or Get Left Behind

Behold the Roth 401(k), the retirement savings tactic growing in popularity among younger and more affluent employees, and offered by ever-increasing numbers of employers.

Driving the boom are legislative changes in 2006, 2011 and 2012 that expanded use of the plans, and a marked change in the demographics of 401(k) account holders.

According to a study last year by human resources consultants Aon Hewitt, "2013 Trends & Experience in Defined Contribution Plans," half of all employers now offer Roth 401(k)s, up from just 11 percent in 2007.

"Continued changes to legislation around Roth, coupled with increased awareness and understanding of these plan features, are driving more employers to add Roth savings feature to their plan," said Rob Austin, the company's retirement research director, in a prepared statement. "Because of the potential tax benefits, employees increasingly see Roth accounts as attractive savings options and we anticipate that the use of Roth will continue to rise."

This year, the firm took a closer look at account holders in its April study, "Roth Usage in Defined Contribution Plans,"  revealing that 17.2 percent of employees in their 20s opted for a Roth 401(k) compared with less than 9 percent of those in their 50s.

According to salary, 13.6 percent of employees earning from $60,000 to $79,000 and 12.8 percent of those earning from $80,000 to $99,000—a total of 26.4 percent—were most likely to use the plans. Just under 8 percent of those earning from $20,000 to $39,000 were enrolled.

The study also indicates that newer employees up to about five years on the job made more use of the 401(k)s than those with longer tenure.

Aon Hewitt analyzed more than 3.5 million eligible participants in over 125 defined contribution plans.

The thinking is that younger workers with lower current tax rates opt to pay taxes upfront on contributions to the 401(k) and withdraw them tax-free at retirement, rather than pay higher taxes on IRA withdrawals in their later years.

Highlights of the Roth 401(k) include:

  • Higher contribution limits: This year, $17,500 can go into the 401(k) compared with $5,500 for the Roth IRA.
  • No income limits for contributions.
  • Loans and certain withdrawals are allowed.
  • Tax-free, penalty-free distributions when the account holder reaches 59-1/2, dies or is disabled but only if the account is at least five years old.
  • Employers can match contributions.

Whether the Roth 401(k) contributions are better than before-tax contributions depends on the employee's tax rate today and what it'll be at retirement. If rates are the same, there's no difference in benefits. If tax rates are higher at retirement, the Roth 401(k) is the choice to make. But lower tax rates in retirement mean that before-tax contributions will mean more income, according to the study.

Want to join the 401(k) parade? An in-plan conversion allows account holders to convert existing funds to a 401(k). But they've got to pay taxes on the converted amount in the year they do it. One catch: Money to pay any additional taxes has to be available in another account—payment can't come from the 401(k).

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