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 [email protected].