While most people are justifiably upset over the most recent tax law changes under H.R.1, I’m reflecting on more advantageous tax bills of ages past. In 2001, Congress passed EGTRRA which created the Roth 401(k), the best thing to happen to retirement. Unfortunately, this gem is often overlooked by employees or hidden in a stack of new hire paperwork. To understand the magnitude of this account, let’s go through the evolution of the individual retirement accounts before it.
Most people don’t know the world without the IRA or 401(k), but they are both relatively new creations. The IRA, individual retirement account, was created as a part of the Employee Retirement Income Security Act of 1974 (ERISA). The Revenue Act of 1978 enabled the creation of the 401(k). However, the Revenue Act did not explicitly create the 401(k), and the story around its inception is a bit of financial folklore. Folklore says that Ted Benna, nicknamed the father of the 401(k), was sitting in his office pouring over the Internal Revenue Code which he “discovered” Section 401(k). But Benna tells a different story, during the two years between the passage of the Act and its effective date, “[m]any people, including me, were aware of the portion of the IRS Code that I used to design the first 401(k) savings plan. Because this provision was added to the Code for an entirely different purpose, no one had considered using it in the manner that I was about to propose.”
The 401(k) plan that Benna created is now known as the traditional 401(k). Generally, the traditional 401(k) is what we think about when we think of a 401(k). The plan is characterized by an employee’s pre-tax contributions which reduce her taxable income while simultaneously saving for retirement. As a bonus, the employer has an option to make deductible matching and profit sharing contributions. Because the contributions and earnings are not taxed until withdrawal, traditional 401(k)s are also referred to as tax-deferred accounts.
Unlike the 401(k), the Roth IRA was created entirely by legislation and not by a creative interpretation of the tax code. The Roth IRA was included in The Taxpayer Relief Act of 1997 as “Nondeductible Tax Free Individual Retirement Accounts” named for its sponsor Senator Bill Roth. Contributions were the opposite of the traditional 401(k)—contributions were made after tax, so a taxpayer was not entitled to a tax deduction, but are withdrawn tax-free. The downside of this account was that contributions were limited to $2,000 and only those making less than $100,000 were eligible to contribute. The contribution and income levels have been increased to account for the cost of living.
Now that we have a background on the individual retirement account, here are three reasons why the Roth 401(k) is your retirement’s BFF.
Your Income doesn’t matter
Over 20 years later, the Roth IRA still has significant income restrictions. For single taxpayers, the income limit is $137,000. Married taxpayers can make up to $203,000 before being wholly excluded. The Roth 401(k) is the option for those who are excluded from Roth IRA contributions.
You can contribute three times as much.
In October or November, the IRS releases the Cost of Living Adjustment (COLA) increases for retirement plans for the next tax year. The contributions for the 2019 contribution for IRAs (traditional and Roth combined) was raised to $6,000 from $5,500 for the first time in five years. Taxpayers over the age of 50 are eligible for an additional “catch up” of $1000.
Employees can contribute a maximum of $19,000 to their 401(k) in 2019, up from $18,500 in 2018. If the employee is over the age of 50, they are entitled to an additional $6,000 as a “catch up provision.”
In plans with the Roth 401(k) option, an employee has the potential to contribute significantly more pre-tax and after-tax money to their retirement.
You have creditor protection
401(k)s are generally safe from creditors because ERISA covers them. This protection extends to 401(k) rollover. But 401(k)s are not protected from child support and divorce obligations.
If a Roth IRA is not funded by a rollover, it is a contributory IRA. Unfortunately, contributory IRAs are not entitled to the same protection as 401(k)s. Although they are protected once a person files for bankruptcy, they are not completely protected from creditors. States have various levels of protection from being completely exempt to partially exempt. For example, California only exempt IRAs to the extent “necessary to provide for the support of the judgment debtor when the judgment debtor retires and for the support of the spouse and dependents of the judgment debtor, taking into account all resources that are likely to be available for the support of the judgment debtor when the judgment debtor retires.”
Some advice…
Not all employer plans have a Roth 401(k) option. In those instances, the Roth IRA is probably the best option for tax-free retirement savings. But if you make too much money to contribute, consider meeting with your tax professional and financial advisor to discuss a “backdoor Roth.”
Many are concerned about 401(k) fees and the lack of investment options. Thankfully, 401(k) options have greatly expanded with more plans offering Self Directed brokerage accounts. These accounts provide access to common stocks, bonds, and ETFs which triple your plan’s investment options. In terms of fees, over the last five years, increased litigation has incentivized employers to find a way to drastically reduce fees as a way to insulate themselves from litigation. Ultimately, the Roth 401(k) enables more people to benefit from the joys of tax-free retirement savings with additional legal protections.