They are coming in 2006 and may be useful for high-income clients.

    If you have not heard about the Roth 401(k), you will soon: Beginning January 1, 2006, the IRS will implement the new Roth 401(K) provision of EGTRRA (Economic Growth and Tax Relief Reconciliation Act of 2001). The Roth 401(k) is similar to the Roth IRA in that after-tax money is being saved and grows tax-free, but, as its name suggests, the new account will fall under 401(k) rules.
    Many advisors are reluctant to discuss the Roth 401(k) with clients until they have more information. This article will provide you with a thorough understanding of the benefits and potential drawbacks of the new Roth 401(k) and will give you an implementation plan for your clients.
    Overview: The IRS has proposed amendments to the regulations under sections 401(k) and (m) of the Internal Revenue Code. Under section 402A, beginning in 2006, a plan may permit an employee who makes elective contributions to designate some or all of those contributions as Roth contributions. Unlike pretax elective contributions, which currently are included in gross income, a qualified distribution of designated Roth contributions is excluded from gross income.
    Contributions must remain in the plan for five years to qualify for the tax advantage of owing no taxes on proceeds, including any investment gains. Of course, participants have already paid tax on their contributions, but not on the interest accumulation.
    Advantages to your clients: The Roth plan may be an opportunity for your clients to grow their retirement savings-even those who are ineligible for the Roth IRA because of income caps can contribute to the Roth 401(k).
    Participants with a regular 401(k) or a regular Roth IRA will still be able to contribute to those accounts; the Roth 401(k) is simply another option. Contributions to a Roth 401(k) will be held in a separate account from contributions to the regular 401(k). The participant decides what percentage of his or her contributions go to either account.
    This account is well suited for clients who anticipate retiring in a higher tax bracket than they are in currently. The Roth 401(k) has an additional advantage for younger workers: the longer the time horizon, the greater the tax benefit, as the employee is exempting more investment earnings from taxation.
    Rules relating to designated Roth con-tributions: The proposed regulations provide special rules relating to designated Roth contributions under a section 401(k) plan. The proposed regulations would amend Section 1.401(k)-I (f) to provide a definition of designated Roth contributions and special rules with respect to such contributions. Under these proposed regulations, designated Roth contributions are defined as elective contributions under a qualified cash or deferred arrangement that are: (1) designated irrevocably by the employee at the time of the cash or deferred election as Roth contributions; (2) treated by the employer as includible in the employee's income at the time the employee would have received the contribution amounts in cash if the employee had not made the cash or deferred election (e.g., by treating the contributions as wages subject to applicable withholding requirements); and (3) maintained by the plan in a separate account. The proposed regulations provide that contributions may be treated as designated Roth contributions only to the extent permitted under the plan.
    Other rules: A designated Roth contribution must satisfy the requirements applicable to elective contributions made under a qualified cash or deferred arrangement. These proposed regulations do not provide guidance with respect to the taxation of the distribution of designated Roth contributions.
    Administrative requirements: A traditional 401(k) plan would need to be formally amended to add the Roth option. Payroll records would need to reflect after-tax Roth 401(k) contributions separately from pretax 401(k) contributions. The third-party administrator for the plan would need to be notified to begin separate tracking and record-keeping for the Roth and traditional 401(k)s. (Tracking and record-keeping costs should not increase significantly.)
    If a plan sponsor adds a "qualified Roth contribution program" to its 401(k) or 403(b) plan, participants may designate all or a portion of their elective contributions as Roth contributions. Accumulated earnings on Roth contributions also are distributed completely tax-free. In a Roth 401(k), income taxes are paid at participants' regular income tax rates at the time of contribution, and earnings and withdrawals are not taxed providing withdrawals begin after age 591/2 and that five years have elapsed from the date of the first contribution to the plan. Taxes and penalties are waived if a participant dies or is disabled. Participants must take minimum distributions beginning the year after they turn 701/2. A Roth 401(k) can be rolled into a Roth IRA if the participant leaves the company, relieving the participant from taking minimum distributions.
    Roth contributions are treated as pretax elective deferrals for plan testing purposes. The combined deferral amount of both pretax and Roth contributions may not exceed Code Section 402(g) limits ($15,000 for 2006, plus catch-up contributions of $5,000).
    Because Roth contributions are elective deferrals, they must be fully vested and subject to the same distribution restrictions as pretax elective deferrals (no earlier than termination of employment, death, disability or attainment of age 59 1/2). Roth contributions must be aggregated with pretax elective deferrals for ADP testing purposes (if not in a safe harbor plan).
    A plan can provide ordering rules for distributions of excess contributions from a failed ADP test. Or, a plan may permit a participant to elect to attribute the excess contributions to pretax or Roth contributions.
    A plan sponsor also will have to track a five-year holding period for Roth contributions, as qualified distributions cannot be made during the five-calendar-year period beginning with the first calendar year in which a participant makes a designated Roth contribution to the plan. If a distribution is made during this five-year holding period, distributed earnings will be subject to taxation. Also, if Roth contributions are made under a plan that provides for automatic lRAs of terminated participants' accounts of $1,000 to $5,000, separate IRAs will have to be established for each account's Roth contribution portion and pretax contribution portion.
    High-income individuals may be interested in Roth contributions because they can accumulate earnings on a tax-free basis (until death) if the Roth contribution is rolled over into a Roth IRA. This is because Roth IRAs are not subject to required distributions after age 70 1/2.
    Many plan sponsors are interested in the new Roth 401(k) but want to wait until final regulations are in place before adding it as an option. Once the unknowns are resolved, plan sponsors will likely embrace the Roth 401(k).
    Unfortunately, the benefits of the Roth 401(k) may be short-lived unless Congress acts to extend the law. As currently written, the Roth provision will end in 2010, as will the entire EGTRRA. It is uncertain what will happen when the sunset provisions kick in, potentially eliminating future contributions to Roth 401(k) plans. Congress may choose to extend some or all of EGTRRA; however, Congress has yet to do so. Even if the Roth 401(k) is discontinued in 2010, it appears that at least contributions made during the five years that the Roth 401(k) was available would simply continue to grow in that account until the participant could make qualified withdrawals.
    Action plan: If your clients intend to add Roth contributions to an existing 401(k) plan, you will want to consider these action steps:
    1. Adjust the plan's record-keeping and payroll systems to separately account for Roth contributions.
    2. Prepare and distribute employee communications describing the benefits of Roth contributions, including a revised Summary Plan Description or a Summary of Material Modifications.
    3. Obtain new deferral election forms from participants prior to the time that Roth contributions are permitted.
    4. Amend the plan to provide for Roth contributions and include provisions detailing the order in which distributions will be made from pretax contributions and Roth contributions. Plans must be amended by the end of the plan year in which Roth contributions are first permitted. For example, for a calendar-year plan that allows Roth contributions starting in 2006, an amendment to the plan will be required by December 31, 2006.
    At first glance the Roth 401k or 403(b) plans seemed to hold little attraction for plan participants as a personal savings vehicle, and seemed to be a lot of hassle for sponsors and record keepers. However, because they allow participants to better customize their retirement savings based on individual circumstances, the Roth 401(k) and 403(b) both appear to be worth the effort for plan sponsors and employees. For plans that allow Roth elective deferrals, the question will be: traditional 401(k) elective deferral or Roth after-tax elective deferral?
    Plan sponsors should consult with their attorney before deciding. The right decision for any individual will depend on a number of currently unknown factors, including our future tax system, future investment returns of the deferrals, inflation rate and future personal income and expenses.

Ken Ziesenheim, JD, LLM, CFP, is president of Thornburg Securities and managing director of Thornburg Investment Management. He can be reached at