The new tax law that resolved the “fiscal cliff” back in January will prompt many more companies to offer their employees a Roth 401(k) plan in addition to a traditional 401(k) plan.
In a traditional 401(k) plan, employees contribute pre-tax earnings, the assets grow tax-free, and an employee can withdraw them at retirement age and pay ordinary income tax on the withdrawals.
With a Roth 401(k), employees contribute post-tax earnings, but when they withdraw the assets years later, the withdrawals are tax-free.
Roth 401(k)s have been around for a few years, but they haven’t been very popular, in part due to numerous restrictions on the ability of employees to transfer existing 401(k) assets into a Roth account. But the new fiscal cliff law allows employees to freely convert any or all of a traditional 401(k) into a Roth 401(k), simply by paying income tax now on the amount transferred.
As a result, Roth 401(k)s may soon become a very desirable employee benefit. They will appeal to anyone who expects to be in a higher tax bracket at retirement, who expects tax rates to increase generally, or who has many years left to work and would rather pay tax now on a small asset balance rather than tax later on a larger account balance.
Roth 401(k)s will often be more attractive than Roth IRAs, because (1) the annual contribution limits are much higher for a Roth 401(k) than for a Roth IRA, and (2) high-income individuals can’t make Roth IRA contributions, but they can make Roth 401(k) contributions.