Most places of employment will offer a variety of retirement plans you can choose to make use of. Two commonly asked questions are whether a Roth 401(k) is the same as a Roth IRA retirement account and is either one better than a traditional 401(k) plan.  While there are significant differences, any type of IRA & retirement plan investing is a great idea; for the past 10 plus years the average American actually had a negative savings rate!

The Roth IRA

A Roth IRA and a Roth 401(k) are two very different savings instruments. Both have the same concept however. Basically, you make contributions to plan for retirement. There are no tax deductions for these contributions. Yet, upon your retirement, you can withdraw your contributions and additional earnings tax-free. While it would be wonderful to have a simple answer to these common questions, one type is not necessarily better than the other. It will greatly depend on your personal preferences and circumstances. The right choice for you will depend on your specific situation and expectations.

The Traditional 401(k)

With a traditional 401(k), the employee will contribute a specified percentage of their salary to a plan that is employer-sponsored. Many companies will make contributions to your account, and some companies will even offer a match of up to 100% of your contributions. No contribution that is made to the traditional 401(k) is counted as taxable income. All of the gains that are accumulated in the account are tax-deferred. Upon withdrawal, the amount is taxed as if it were ordinary income. The traditional 401(k) is similar to a traditional IRA account and account owners will have to begin taking withdrawals at age 70 1/2.

Roth 401(k)

When dealing with a Roth 401(k), the contributions that are made by the employer are kept separate. These contributions will receive the same tax treatment as a traditional 401(k).

A Roth IRA does not have a withdrawal requirement. You will never be required to make mandatory withdrawals from the account. Roth 401(k) accounts do have a withdrawal rule, and owners will be required to begin withdrawing when they reach 70 1/2. One way to avoid the mandatory withdrawal rule is to rollover the Roth 401(k) into a Roth IRA retirement account. Keep in mind that Roth 401(k) accounts are available to every worker, while Roth IRAs have an income restriction.

The Roth 401(k) plan has a maximum contribution limit. In 2009, the limit is $16,500. However, there is a $5,500 catch-up contribution that is allowed for workers who are over the age of 50. Combined, employees can contribute up to $22,000 per year into their account.

Contribution Limits: Roth IRA & 401(k)

IRAs have a very significant difference from a 401(k). With an IRA retirement account, the contribution limits are lower. This is because these accounts are not sponsored by your employer. For 2009, Roth IRA contribution limits are set at $5,000. Employees are allotted an additional $1,000 for catch-up, totaling $6,000 for the year if you are over 50. It is possible to have more than one type of retirement account. If you have an IRA and a 401(k), you can contribute the maximum amount to both accounts. Now, the question remains, what’s better, a 401(k) or a Roth IRA?

Choosing Roth 401(k) or Roth IRA

An analysis conducted by William Urban from Bingham, Osborn and Scarborough, indicates that the Roth 401(k) plan “might be the better choice for more people than commonly understood.”

The popular belief is that a Roth 401(k) makes more sense, especially if you are planning to be in a higher tax bracket upon retirement. The analysis showed that if your tax bracket falls in retirement years, the accumulation in the Roth might make that the better choice. This is usually the case if employees can afford to contribute the maximum amount allowed. Many times, younger workers are in the lower tax brackets. This minimizes the immediate tax benefits of the traditional 401(k), making the Roth fund a better choice. 

Regardless of your decision, going with any tax advantaged savings account is critical to save for retirement. More and more people file for bankruptcy because they did not have a large enough savings when a financial emergency occurred such as a sickness, loss of a job, or death in the family.

There’s a new kind of defined retirement plan on the market, but you may have to ask your employer to add it to your current plan.

In 2001, Congress passed the Economic Growth and Tax Relief Reconciliation Act (EGTRAA), which provided a variety of changes, adjustments and extensions to rules for retirement plans to be phased in during the ensuing 10 years. Among those provisions was the creation of the Roth 401(k), a hybrid that allowed contributions of after-tax dollars (like a Roth IRA) through salary deferral up to $15,000 (2006 limit) with a $5,000 catch-up allowed for people over age 50 (like a 401(k) plan.)

Roth 401(k) plans haven’t received much attention in the intervening years because that particular part of EGTRRA didn’t take effect until January 2006. Most employers, according to a survey by Hewitt Associates, have not yet added the Roth 401(k) to their retirement offerings, and only one-third of companies say they are “very” or “somewhat” likely to add it. Those who do, however, find the most Roth 401(k) fans among workers in their 20s, 14% of whom select the new plans when offered, the highest rate for all age groups.

That’s not surprising. Roth 401(k)s operate on the same assumption as Roth IRAs: that those who use them will be in a higher tax bracket after retirement than they are now. Both Roth products are funded with after tax dollars, making withdrawals of contributions and earnings tax free. Traditional 401(k)s and traditional IRAs work the opposite way: dollars are contributed pre-tax or with an attached tax deduction now, and contributions and earnings are taxed upon withdrawal, when the employee expects to be in a lower tax bracket.

In May 2006, Congress eliminated income restrictions, which were $110,000 for individuals and $160,000 for married couples, on conversions from traditional IRAs to their Roth counterparts. This provision, however, doesn’t kick in until 2010—the year the new Roth 401(k)s end. Individuals who earn more than $110,000 cannot open a Roth IRA, although many tax and investment professionals expect the IRS to allow those over the income limit to open Roth IRAs to receive rollovers from the Roth 401(k)s.

If Congress makes no effort to extend the lifespan of the Roth 401(k), those funds will be eligible to roll into a Roth IRA. A rollover may also be beneficial to someone turning 70½. At that age, Roth 401(k) accounts, traditional 401(k) accounts and traditional IRA accounts begin minimum required distributions. A Roth IRA has no mandatory distribution, so the money in them can continue to grow tax-free for as long as you wish—even for the beneficiary of your Roth IRA account.

Like Roth IRAs, Roth 401(k) contributions are subject to a five-year investment requirement, meaning that to receive distributions without penalty, the account holder must be age 59 ½ and have held the account for five years. When rolling funds from a Roth 401(k) to a Roth IRA (or in any other conversion) keep careful records to verify the date you made the contributions so you can establish the base for that five year holding period.

Many factors can affect your personal decisions about traditional versus Roth, and 401(k) versus IRA, including your age, your tax bracket now, your expected tax bracket in retirement, the amount you are contributing, and your ability and desire to pass funds to future generations. An investment professional can help you weigh the pros and cons of each account and contribution type to determine which best meets your needs.

If you are an employer, your investment and tax professionals can help you decide whether adding the Roth 401(k) contribution provision to your plan (a relatively simple and low-cost change) makes sense for you and your employees.

Why Should I Roll My 401(k) to a Roth IRA?

Rob works for a company that offers a 401(k) plan. He has decided to leave his current job, accepting a new job offer with a different employer. He now has some decisions to make regarding his current 401(k) plan. Rob has some options that are available. He can cash it out and take what is in the account, minus taxes, but this is not advised. He asked his advisor the question, “can I roll my 401(k) to a Roth IRA?” The answer is yes, and it is probably the best thing to do. If Rob does decide to go ahead with the rollover, he must already have an existing Roth IRA account. If he does not, he will have to open a new account before proceeding with the rollover process.

Types of Rollovers:

Direct Rollover from 401(k) to Roth IRA

In regards to his 401(k) plan, Rob has two types of rollover options to choose from. The first is a direct rollover. This is usually the best option. With a direct rollover, the funds from Rob’s current 401(k) account will simply be sent over to the existing Roth IRA account. The only requirement is that Rob must already have an open Roth IRA account. With this type of rollover, there will be no IRA penalties or taxes involved. It is a simple matter of transferring the funds from one account to the other and the process moves very quickly.

Indirect Rollover from 401(k) to Roth IRA

The other type of rollover Rob can elect is indirect. This can be a bit complicated than the direct rollover. Rob has been trying to find the answer to whether he can roll his 401(k) over to a Roth IRA. Now that he has determined that is possible, some valuable time may have already been wasted, especially if he is opting for the indirect rollover. An indirect rollover occurs when there were distributions made from the 401(k). For example, Rob will receive a check for the amount from his 401(k) account. When he receives this check, he will immediately notice that the amount does not coincide with his recent statement. This is because 20% has been taken out of the amount to pay for taxes. This is where things can get complicated. For Rob to complete a rollover, he must follow all IRA rules. First of all, the rollover must consist of the entire amount that was in your 401(k). For example, if Rob has $100,000 in the account, he will receive a check for $80,000. When he goes to perform the indirect rollover, he will have to find a way to produce that 20% that was taken for taxes. This means that it is his responsibility to add $20,000 to the amount of the check. This may sound like a lot of money, and it is, seeing as he has to come up with it quickly, but as long as Rob follows the rules, he will receive that 20% in his tax returns at the end of the year.

Indirect Rollover: 60 Days to Complete the Transfer of Funds

As if that is not complicated enough, there is more! In addition to the 20% subtraction for taxes, Rob must now abide by a set timeframe in which to complete the rollover. From the date the he receives a check for the distribution from his 401(k), he will have only 60 days to complete the rollover. If Rob does not currently have a Roth IRA, he will have to take the time to open a new account. Upon making the transfer when the account is ready, Rob will have to make sure to include the $20,000 taken for taxes. So, he has 60 days to come up with the money, open a Roth IRA account and complete the transfer.

Requirements for a Roth IRA

Now that Rob has received all of the information he needs to determine that he can roll his 401(k) to a Roth IRA, he now must make sure that all eligibility guidelines for the Roth IRA are met. Of course, if Rob already had an existing account, he does not have to worry about this. However, if he does have to open a new Roth IRA, it is important for him to be aware of the Roth IRA rules. One of the most important factors will be the amount of Rob’s income. According to Roth IRA rules, Rob’s current adjusted gross income cannot exceed $120,000 per year. If Rob’s income exceeds this amount, he will not be able to open a Roth IRA account, in which case, he will have to roll his 401(k) over to a different type of retirement account.

Since Rob is leaving his current job, he must make a decision regarding his 401(k) plan. Rolling over his plan to an IRA retirement account is his best option. A direct rollover is preferred, because it is a faster and simpler process, but it is not always possible. The entire process of rolling over your 401(k) to a Roth IRA, regardless of what type of rollover is conducted, is not overly complicated as long as you abide by IRA rollover chart rules.  Rob no longer needs to ask his advisor, “can I roll my 401(k) to a Roth IRA?”