Roth 401(k) versus SIMPLE plans

Published December 8, 2007 in the North County Times
(This is the unedited version. The published article was shortened)

Does your 401(k) plan offer the new “Roth” feature?

This option allows you to start directing your payroll deductions into a Roth account instead of one that is pre-tax. Although you don’t receive a current deduction, distributions are all tax free including the earnings. If you believe that your traditional deferred retirement plan is already sufficiently funded, it makes sense to forego the deduction and shift to a Roth. How can any investment compete with the promise of earning income tax free for the rest of your life?

This addresses the problem of many who have been locked out of the Roth IRA option, because their incomes have been too high. High-income earners have been discriminated against in this regard as in so many other parts of the tax law. Now, the coveted Roth is available to many more workers.

Best of all, the matching 401(k) contributions, paid in by the employer, also go into the Roth account. Nevertheless, these are still deductible by the employer. Whether this was the intention or not, this has made possible “deductible Roth contributions” for the very first time. In a small business this is especially huge, since the owner is able to build his Roth account with partially tax-deductible contributions.

In fact, the ability to make Roth contributions is making many small employers rethink their use of the very popular SIMPLE alternative. SIMPLE plans were introduced back in 1997 as a way to allow small employers to offer voluntary retirement plans without a lot of complicated rules. Prior to that, small employers had trouble with setting up such a plan because 401(k) plans were just too complicated and a high level of employee participation was required.

Under a SIMPLE plan, each employee can stash away a total of $10,500 tax free, or $13,000 if they are fifty or older. These 2007 limits are not going up in 2008. The employer generally must kick in a 3% match, for employees who participate. There are no minimum participation rules and all employer contributions vest immediately, so that administration costs are usually minimal or free depending on whom you select as the financial institution.

Even though a SIMPLE plan is a good thing, you should consider if the “safe harbor 401(k)” is going to be better for you going into 2008. The “safe harbor 401(k)” works a lot like a SIMPLE plan but can be set up to allow Roth contributions. There are some additional costs involved. However, since a switch can only be done in January, you should consider the following additional reasons for doing so immediately, before that:

Similar rules allowing less participation- Like with the SIMPLE, you do not need a set percentage of employee participation. In fact, if you are the boss, you could be the only one involved. However, it does mean a higher employer match, generally 4%. As with the SIMPLE there is immediate vesting of employer contributions.

Higher limits- Here is another advantage for the 401(k) over the SIMPLE. 401Ks have always allowed a slightly more generous voluntary contribution. Lately, however, the divergence is becoming significant. For example, in 2007 and 2008, the voluntary contribution maxes out at $15,500 or $20,500 if 50 or over. This is close to 60% greater than that offered by SIMPLE plans and allows those able to do so to stash away more for their retirement.

The ability to do even more- A SIMPLE plan must stand alone. However, once you have a 401K plan, you can also add a “profit sharing plan”, which permits major additional employer contributions. If you are self-employed with no employees, the niftiest way to max out your retirement contributions is to set up a single member 401(k) plan plus a profit sharing plan. Packages that combine both are available from numerous financial institutions.

However you slice it, a 401(k) type of employee program is almost a required company benefit in order to attract and keep good workers. If your employer does not yet offer one, prod your boss to get on the stick.

Many thanks to Donna Neuhauser, APA, from Pensions Ltd in Escondido for help on this article.