In our previous post we looked at the concept of the Roth 401k, which is simply the option to contribute dollars on an after-tax basis to a traditional 401k plan (assuming that the plan sponsor has amended the plan document to allow such contributions, as required by the Internal Revenue Code).
Although the IRS introduced the Roth 401k in January 2006 (as part of the Pension Protection Act of 2006), it remains an unknown option to many business owners and high-income professionals — the very people who could benefit from it the most.
That’s not to say that the Roth 401k option is a good fit for all business owners or other high-income workers. Each individual must look at his or her current financial situation and goals — preferably with the help of a financial advisor — before deciding on Roth 401k contributions.
Current-year income taxes are a key consideration when deciding whether to add “Roth dollars” to a 401k. These funds are taxable in the current year, so the more that a business owner contributes to her 401k on a Roth basis, the greater her tax bill is likely to be on the following April 15.
However, doing so could help her avoid the higher tax rates which many expect will be in place years from now, when she withdraws the funds from her 401k. Plus, if she expects to be in a higher tax bracket when the IRS requires her to begin taking withdrawals (typically age 59-1/2), the Roth contributions could save her even more money.
Roth IRA income limits also could be a factor for some business owners and high-income professionals thinking about the Roth 401k option. Each year the IRS sets maximum-income levels (which differ based on the taxpayer’s filing status — single, married, or married but separated) at which an individual may contribute to a Roth IRA.
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For those whose income is (or might be) close to the applicable limit, traditional 401k contributions might be a better option because they reduce current-year taxable income, thus allowing the individual to make Roth IRA contributions while also building up their traditional 401k balance.
Added record-keeping and payroll processing: When considering whether to offer the Roth 401k option to their employees, business owners should be aware of the extra record-keeping and payroll processing it requires. Whether you outsource these tasks or handle them in-house, remember that the Roth 401k option has the potential to help you and your most valuable employees significantly increase retirement savings.