Studies indicate that many people do not save for retirement because they do not understand all the 401k gibberish. First there’s the traditional 401k, then there’s the Roth 401k, annuities, ROTH IRA, Individual Retirement Accounts (IRAs) and your savings account at your local bank. Out of all these options, the Roth IRA has come out to be the best and the most popular option. Why? Because its tax-free growth and flexibility of making withdrawals cannot be competed against! Studies suggest that compared to traditional 401k or 403b plans, a retiree who saves in a Roth IRA will have more savings upon retirement. Total Roth IRA assets in the United States totaled $178 billion as of December 2006 (Source: Investment Company Institute).

The Roth IRA was introduced under the Taxpayer Relief Act of 1997, pioneered by the late Senator William V. Roth, Jr. Under a Roth IRA, an individual can invest in all types of investment vehicles including common stocks, mutual funds, futures & options, certificates of deposit, as well as real estate. The main advantage of Roth IRA is its tax structure. Contributions to a Roth IRA are made only from earned income that has been taxed by the Federal government. Since you already pay taxes before saving your money in a Roth IRA, you are not required to pay federal taxes when you make withdrawals from your Roth IRA. Also, any capital gains you make on your Roth IRA investments can be withdrawn tax-free!

Difference between Traditional IRA and Roth IRA

In a traditional IRA, any contributions you make are tax-deductible and any withdrawals you make will be taxed by the federal government. This works inversely with a Roth IRA where any contributions you make is not tax-deductible (because you have already paid taxes on this), and any withdrawals you make will NOT be taxed by the federal government.

Roth IRA Contribution Limits

Advantages of Roth IRA

i) Roth IRA owners can withdraw up to the total value of their contributions at any point in time, without having to pay the 10% early withdrawal penalty or any federal income taxes.

ii) Upto $10,000 can be withdrawn without any penalty if the owner wishes to purchase a home or principal residence. The home must be purchased by either the Roth IRA owner, his spouse, ancestors or descendants. Also, the Roth IRA owner must not have previously owned a home for at least 24 months.

iii) If a Roth IRA owner dies and his spouse also owns a separate Roth IRA, the spouse is permitted to combine the two Roth IRAs into 1 single account without any penalties or fines.

iv) The Roth IRA does not force distributions upon the owner reaching 70 and 1/2 years of age. This is unlike all tax-deferred retirement plans including the Roth 401k where the owner is required to take minimum required distributions (MRDs) after the age of 70 and 1/2 years. Usually all distributions must be withdrawn by April 1st of the calender year.

v) If the Roth IRA owner expects to be in a higher tax bracket upon retirement, it is advantageous for him to contribute maximum amounts of money towards a Roth IRA. Why? Because money being invested in a Roth IRA is taxed at the current lower tax bracket, and will not be taxed when it is withdrawn upon retirement (and when the Roth IRA owner is in a higher tax bracket). For example, consider an investor who contributes $2000 to a Roth IRA when he is in a tax bracket of 21%, and will be in a tax bracket of 33% upon retirement. This means that investor has already paid 21% x $2000 = $420 in taxes. Upon retirement if the investor wants to withdraw his funds, he would have had to pay 33% x $2000 = $660 under a Traditional IRA. However since the investor has already been taxed at his lower bracket of 21%, he would NOT have to pay taxes upon taking retirement distributions when he is in a 33% tax bracket.

Introduced in January 2006 under a provision of the Economic Growth and Tax Relief Reconciliation Act of 2001, the Roth 401k is different from the traditional 401k plan because contributions are made after-tax (meaning after tax has been deducted off your pay). The Roth 401k is very similar to the Roth IRA; investors receive no tax deduction on annual contributions, but any withdrawals or proceeds will not be subject to tax either. Investors who own 403b plans are also eligible to contribute to Roth 401k. The government was more than happy to introduce this new piece of legislation because it means investors will pay more tax now, rather than making salary deferral contributions as in the case of traditional 401k plans.

The Roth 401k works inversely with a traditional IRA. With a traditional IRA, an investor receives current tax deduction after making contributions. Instead of this money going to the IRS now, it will stay with the investor and he can invest it in stocks/bonds/mutual funds or real estate. Over time, this money will grow tax-deferred. The government likes this idea too because say after 30 years of investing in various stocks/commodities/real estate, an investor has grown his money from $50,000 to $200,000. If he withdraws this money from his IRA, he will have to pay taxes not on the initial $50,000 but on the whole $200,000!

The Roth 401k works inverse with the above idea. The money you earn this year is taxed this year. You make contributions to a Roth 401k from your after-tax earnings. When you reach the age of 59.5 or more, you are eligible to make withdrawals that are not taxable (because they have already been taxed). The prospect of receiving tax-free money upon retirement is an idea liked by many investors. The idea of receiving tax dollars now is very much liked by the government such that some senators have proposed getting rid of traditional 401k plans or IRAs.

Roth 401k Works Best if:

• The federal government increases taxes over time
• You are a high income earner who has a compensation cap on Roth IRAs (maximum compensation cap of $245,000 in 2011)
• The mutual funds or stocks where you put your Roth 401k capital experience significant returns
• You are a young investor and need more time for your account to grow across various investments such as mutual funds, stocks, commodities, etc.
• You are in a lower tax bracket now and will be in a higher tax bracket upon retirement

Understand the Advantages of Roth 401k

i) Unlike the Roth IRA that has income limitations that will restrict high income earners from deducting the maximum tax off their earnings, the Roth 401k has no income limitations. The maximum compensation cap for Roth IRA is $101,000 for 1 individual, or $159,000 for for joint tax payers. In the case of the Roth 401k, there is no such compensation cap.

Note: The contribution limit for Roth 401k for 2011 is $16,500 for people under the age of 50, and $22,000 for people over the age of 50.

ii) Roth 401k provides tax-free withdrawals upon your retirement, and this idea is very appealing to investors.

iii) Also because of uncertainty regarding future tax legislation, it is better to lock in a lower tax rate now, than to wait upon retirement and pay taxes then. This is especially true for young investors who are earning lower incomes.

Disadvantages of Roth 401k

i) If you get terminated from your job or laid off and are forced to take a distribution of your Roth 401k assets, you are NOT exempt from paying taxes and will have to pay them.

Important Things You Should Know

Here are some of the important characteristics of Roth 401k that you should know about

i) Roth 401k is Voluntary – That’s right, Roth 401k is voluntary for employers. In order to offer Roth 401k for their employees, employers have to set up a tracking system that segregates Roth assets from the company’s existing plan. This tracking system is expensive to build and maintain, and employers may not choose to do it at all. If so, your employer will not be eligible to offer Roth 401k.

ii) Also, any matching contributions that your employer makes towards your Roth 401k must be deposited into a traditional 401k plan. Go figure!

iii) Unlike Roth IRAs, people who reach over the age of 70 and 1/2 must take minimum required distributions (MRDs) from their Roth 401k. This forces investors to take distributions even if they don’t want them or need them. Why wouldn’t they want them? Some investors like to leave behind inheritances for their children and grandchildren, and taking MRDs is not an option.

iv) If you think you are in a lower tax bracket now and will be in a higher tax bracket upon retirement, use a Roth 401k. If you think you will be in a lower tax bracket upon retirement and are thus in a higher tax bracket now, a traditional 401k makes sense.

v) Assets in a traditional 401k cannot be converted into a Roth 401k.

Many plan sponsors want to know how their 401k plan stacks up to the typical or average plan. This is often the first question asked when attempting to determine whether an effort should be made to upgrade the features and benefits of the plan.

Eligibility: Short service requirements (less than three months of service) are now common for participant contributions. In 1998, only 24 percent of plans allowed employees to begin contributing to their 401k plans immediately upon employment. Now, 60.3 percent of all plans permit immediate participation in their 401k programs. Short service requirements are even more common at large companies — 74.2 percent of companies with 1,000 or more employees provide immediate eligibility and 89.7 percent provide eligibility within three months.

• Immediate (one month or less)   60.3%
• 3 months or 90 days        15.3%
• 6 months or 1000 hours                 9.8%
• 1 year    11.2%
• Other    3.3%

Minimum Age Requirements: The common minimum age requirements for participation are:

• None     43.1%
• 18 Years Old       20.1%
• 21 Years Old       35.4%
• Other Minimum Age      1.5%

Vesting Schedules: Thirty-nine point five percent (39.5%) of plans provide immediate vesting for matching contributions, while 23.0 percent provide immediate vesting for profit sharing contributions. Among plans that do not have immediate vesting, graduated vesting is the most common arrangement for all plan types.

Automatic Enrollment: Thirty-eight point four percent (38.4%) of plans have an automatic enrollment feature. Automatic enrollment is most common in large plans — 53.7 percent of plans with 5,000 or more participants report having automatic enrollment. The most common default deferral is 3 percent of pay, present in 58.0 percent of plans. 53.1 percent of plans automatically increase the default deferral percentage over time.

Seventy-two percent of plan sponsors use a life-cycle or target date fund (TDF) as the default investment option, and 13% use a balanced or lifestyle fund. Sponsors of smaller plans are more likely to use TDFs — 78% of plans with $10 million to $99 million in assets use TDFs compared with 68% of plans with $1 billion or more.

Employer Contributions: Company contributions average 2.1% of payroll.

Numerous formulas are used to determine company contributions. The most common type of fixed match, reported by 27% of employers, is $1.00 per $1.00 up to a specified percentage of pay (commonly 6%). Twenty-three (23%) of all plans match $0.50 per $1.00 up to a specified percentage of pay (most commonly 6%).

Company Stock as Match: Only 17% of employers invest the employer matching contribution exclusively in company stock. Of those that do default the match exclusively to employer stock, there are fewer restrictions associated. Currently, 84% of these plans allow employees to diversify or transfer employer matching contributions at any time.

Employee Participation Rate: Eighty-nine percent (89%) of U.S. employees at companies offering a 401k program are eligible to participate. On average, 87.3 percent of eligible employees have a balance in the plan. Twenty-two point four percent (22.4%) of plan participants are no longer actively employed by the plan-sponsoring company.

Investment Options: The number of funds offered to plan participants appears to be leveling out after many years of steady increase. Plans offer an average of 18 funds for both participant and company contributions. The funds most commonly offered are actively managed domestic equity funds (87.3 percent of plans), actively managed international equity funds (86.0 percent of plans), and indexed domestic equity funds (82.4 percent of plans). The availability and use of target-date funds continues to grow. 62.3 percent of plans now offer them.

Investment Committee: Thirty-three percent of plan sponsors have no investment committee, though it varies heavily by plan size. More than half the plans with less than $5 million in assets did not. Fewer than one in 10 of plans with more than $5 million in assets did not have such a body.

Investment Policy Statement: Ninety percent of all plans have a written investment policy statement, but only about half of those with less than $5 million in assets do.

Investment Advisors: Sixty-six point seven percent (66.7%) of companies retain an independent investment advisor to assist with fiduciary responsibility. For 54.2 percent of those companies, the fee is a fixed amount and for 36.1 percent the fee is percentage of plan assets.

Investment Advice: Advice is offered in 60.1 percent of plans. Twenty-one point six percent (21.6%) of participants used advice when it was offered. Participant usage tends to be greatest in small plans.

Roth 401k: Among plans that permit participant contributions, 41.3 percent allow participants to make Roth after-tax contributions. Only 13.0 percent of participants make Roth contributions when offered the opportunity.

Catch-up Contribution: Catch-up contributions for participants aged 50 and older are permitted in 98.0% of plans. Thirty-one percent (31.0%) of these plans offer a match on the catch-up contributions.

Self-directed Brokerage Accounts: Self-directed brokerage accounts are offered in 15.5 percent of plans, while open mutual fund windows are offered in 8.3 percent of plans. On average, plans invest 2.2 percent of plan assets through brokerage windows and 1.5 percent through mutual fund windows.

Loans: Sixty-one percent of the 401k plans offer a plan loan provision to participants. The loan feature is more commonly associated with large plans (as measured by the number of participants in the plan). Ninety-four percent of plans with more than 10,000 participants included a loan provision, compared with 35 percent of plans with 10 or fewer participants. There is modest variation in participant loan activity by plan size, ranging from 17 percent of participants with loans outstanding in 401k plans with 26-100 participants to 23 percent of participants in 401k plans with more than 5,000 participants. Loan ratios vary only slightly when participants are grouped based on the size of their 401k plans (as measured by the number of plan participants). Among participants in plans with 100 or fewer participants, the loan ratio was 18 percent of the remaining assets, while in plans with more than 10,000 participants, the loan ratio was 15 percent.

Hardship Withdrawals: Hardship withdrawals are permitted in 85.6 percent of plans. The most common reasons for permitting hardship withdrawals include purchase of a primary residence or to prevent eviction or foreclosure (97.9 percent), medical expenses (97.2 percent), and post-secondary education expenses (93.5 percent). 1.9 percent of participants took a hardship withdrawal, when permitted.

Safe Harbor Plan Design: Thirty-four point two percent (34.2%) of plans have a Safe Harbor plan design in lieu of ADP/ACP testing.