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401(k) rules require separate Roth, traditional accounts

Posted On: May. 6, 2007 12:00 AM CST

WASHINGTON—Although the term is common, legally there is no such thing as a Roth 401(k) plan.

A provision in tax legislation, which passed nearly six years ago by Congress and that went into effect Jan. 1, 2006, created what the 2001 law calls Roth contributions.

Roth contributions can only be made when the feature is included in a traditional 401(k) plan or a 403(b) plan, the nonprofit sector's equivalent of a 401(k) plan.

Roth 401(k) contributions differ from traditional 401(k) plan contributions in two key ways. Unlike traditional 401(k) contributions, which are made with pretax dollars, Roth 401(k) contributions and earnings can be withdrawn tax-free. Investment earnings, though, cannot be withdrawn tax-free until five years after an employee first began to make contributions and after he or she reaches age 59½.

For young employees, that means their contributions can accumulate decades of tax-free investment income. Additionally, employees now in a low tax bracket and who move into a higher tax bracket when they retire also could be better off by making contributions to a Roth account rather than to a traditional 401(k) plan.

Federal law makes clear that Roth and traditional 401(k) plan contributions must be kept separate.

Additionally, before a contribution is made, an employee must designate whether it is for the Roth portion or the traditional portion of the 401(k) plan.

An employee decides how much of his or her contribution will go into the Roth account and how much into the traditional 401(k) plan. Any combination is allowed, so long as the total contribution doesn't exceed the overall 401(k) plan limit, which is $15,500 in 2007.