Q:

Subject: Roth 401(k) plans

Mr. Kerstetter,
I am an accounting student pursuing my MBA with a focus in Accounting, satisfying my CPA 150 hour requirement. As a young professional I have been keeping my eye on retirement. So I can get out young and rich! I see there is a new retirement plan coming out Jan. 1, 2006 the Roth 401(k) plan. Unfortunately my company doesn't offer it for 2006. But I had some questions regarding it. The Roth 401(k) plan, is made with after tax dollars and employer matches are made with before tax dollars. Being that we are taxed on these dollars, does the share of taxes paid by our employer increase with the Roth 401(k)?

As I have learned in my tax classes, Employers pay taxes based on their payroll. They pay federal income tax, social security and Medicare, and federal unemployment taxes.

I am under the impression that because traditional 401(k) plans lower our AGI, that because we aren't responsible for tax on contributions, that our employer isn't either.

If this new Roth 401(k) plan contributions are based on after tax dollars, doesn't offering this plan increase an employers tax liabilities? If so, what is the motivation to them to adopt this retirement plan?

Your site is great! I read it everyday thanks for the knowledge and inspiration in my journey.

A:

Roth 401(k)s are obviously so new that all of the details of how they function in real life are not yet settled.  Some of the basics are laid out in this free article from the WSJ.

I noticed a few misconceptions in your email.  Employers do pay a number of payroll taxes on the wages they pay their employees.  These include FICA, Medicare and Federal and State Unemployment taxes, plus occasional local taxes.  Employees are also required to pay FICA and Medicare taxes on their gross pay.

The employer does not actually pay Federal or State income taxes on the wages paid out.  Those are paid by the employees, but are withheld by the employer to be sent to the IRS and State on behalf of the employees.

My understanding of the Roth 401(k) plans is that the amounts put aside into the accounts by the employees will be subject to all of the standard income and payroll taxes by both the employer and employee.  The money being contributed to the account is thus after-tax dollars.  The benefit to the employee is that, if the money is in the account long enough and our rulers in DC don't change the laws, all of the money in those accounts can be withdrawn tax free, including the income it earns over the years.

With the conventional 401(k)s, the employees don't have to report the amounts contributed as subject to income taxes, but do have to pay payroll taxes on that money, as do the employers.  The trade-off here is that every bit of money taken out of the 401(k) or subsequent rollover IRA account will be subject to income tax when withdrawn.  

In regard to employer full or partial matching of employee contributions, these amounts are not currently subject to income taxes, but are hit with the normal payroll taxes.  While these are technically pre-tax dollars in conventional 401(k)s, I don' think that will be possible with the new Roth 401(k)s.  Those are only designed to be funded with after-tax dollars. I haven't studied the actual law; but it wouldn't be consistent for our rulers to allow a mixing of pre-tax and after-tax contributions.

401(k)s of both types are generally very popular with employers because they allow their employees to fund their retirement accounts with their own money rather than additional company funds, as normal company sponsored pension plans require.  In a competitive labor market, employers want to allow their workers the same kinds of benefits that their competitors have in order to attract and retain productive people.

I hope this helps understand this issue a little better.

Kerry Kerstetter

Follow-up:

Wow, Mr. Kerstetter, thank you for the great response. I am not sure how you do it, I guess my problem was a misunderstanding that employers don't pay anything on our traditional 401k contributions. What I have seen from a couple Roth 401k calculators found on smartmoney.com is that the employer match is put in as before tax dollars. I am not sure how they plan on handling the mixed distribution of those. But thank you for your response again!

Update:

Roth 401(k) Offers Tax-Free Bonanza in Retirement – From John Wasik of Bloomberg News.

- posted by Kerry M. Kerstetter, MBA~CPA~ATP~ATA @ 12/26/2005 09:07:00 PM Send this post: