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Roth 401(k)
July 2005

Beginning January 1, 2006, 401(k) plans may permit participants to designate some or all of their contributions as ‘Roth contributions’. Using Roth IRAs as a benchmark, the potential for Roth 401(k)’s popularity is great. As a plan sponsor, it will be your decision whether or not to allow Roth contributions in your 401(k) plan. Although final regulations have not been released, we thought it would be beneficial to provide a summary of the
proposed regulations.

What it is

The regulation defines Roth 401(k) contributions as contributions that are:

  • Designated irrevocably as Roth contributions by the participant at the time of election,
  • Treated by the employer as includible in the participant’s wages at the time the participant would have received the contributions in cash if not contributing them to the plan, and
  • Maintained in separate recordkeeping accounts.

In summary, Roth 401(k) contributions are counted as income and will be taxed in the year the contribution is made. Distributions of Roth 401(k) contributions, including earnings, are tax-free if certain requirements are met.

What’s its History

The 2001 tax act, known as EGTRRA, added Section 402A to the Code. Effective January 1, 2006, new 402A allows 401(k) plans and 403(b) arrangements to add a Roth feature. The IRS issued preliminary regulations in March 2005, which address some of the tax issues related to Roth 401(k) provisions.

How it works

Those plans that choose to add Roth contributions will need to comply with the following guidelines (proposed).

  • The plan is amended to incorporate the Roth 401(k) provision. Participants will receive a revised Summary Plan Description or a Summary of Material Modification outlining the plan’s new provision.
  • Election forms are provided to the participants allowing them the opportunity to designate some or all of their contributions as Roth 401(k) contributions.
  • Roth 401(k) contributions (and distributions) must generally satisfy the same requirements as pre-tax 401(k) contributions.
  • The amount withheld as Roth contributions, will be included in current income as wages or, for partners and owners, as earnings.
  • Record-keeper must separately account for Roth 401(k) contributions. Earnings, losses and other credits or debits applicable to Roth contributions must also be separately allocated to a participant’s Roth recordkeeping account.
  • Contribution limits for pre-tax 401(k) contributions apply to Roth contributions. The maximum limit is the aggregate of both types of 401(k) contributions.
  • Company contributions, including company match contributions, will continue to be made on a pre-tax basis.
  • Roth contributions must be included in the actual deferral percentage (ADP) test in the same manner as pre-tax contributions.
  • Highly compensated employees who must receive a refund from a failed ADP test can choose to have the refund come from their Roth account (if applicable). If Roth contributions are refunded the refund will not be taxed, any earnings included in the refund will be subject to taxation.
  • The tax treatment of Roth 401(k) distributions mirror Roth IRA distributions.
  • Distributable events will match those of pre-tax 401(k) contributions (termination, retirement, death or disability).
  • Distributions from Roth accounts are tax free if the following are met: distributed after the participant reaches age 59 ½, dies or becomes disabled AND has
    had the account for at least five years. If these requirements are not met, the earnings are subject to taxation, and the full distribution amount is subject to
    a 10% penalty tax.
  • Roth 401(k) contributions may be rolled to other 401(k) plans with a Roth feature or to a Roth IRA.
  • Minimum distribution rules do apply.

What the Proponents Say

Depending on the participant’s tax situation, Roth contributions to a 401(k) could have significant impact on a participant’s retirement benefits. Consider the following:

  1. Contributions are taxed now and earnings are tax free. If one suspects her tax rate will be the same or higher at retirement than it is currently, Roth contributions
    might be appropriate.
  2. Distribution of Roth contributions will not be considered income when distributed. This can provide a means of managing taxes at retirement.
  3. Roth contributions may provide estate planning benefits.
  4. Contribution maximums to Roth 401(k) are substantially higher than Roth IRAs.
  5. Eligibility to contribute is not restricted by income level, as in a Roth IRA.
  6. Minimum distributions rules apply; however, Roth accounts can be rolled to a Roth IRA, which are not subject to minimum distributions requirements. Given the complexity of each individual’s tax and/or estate situation, many participants will need to seek tax advice prior to making their contribution decision.

What the Opponents Say

In considering a 401(k) with Roth contributions, there are a handful of issues that must be weighed against the benefits of providing this feature.

  1. The additional administrative challenge as it relates to contributions and distributions. Obviously, maintaining separate Roth 401(k) accounts increases
    the administrative work for the plan, although RPS will be able to support this from a recordkeeping standpoint.
  2. The potential for participant confusion. Pre-tax, posttax or both? This will be the question the participants will have to decide. Participant confusion often hinders participation. In addition, an unclear understanding may lead to participants inadvertently making an unintended or inappropriate election.
  3. Additional cost to the plan could be incurred.
  4. Roth 401(k) comes under a tax act that expires at the end of 2010. Congress will need to extend the act for participants to continue contributing into their Roth
    account.

What’s to Come

As we wait for final regulations, it is believed that Roth 401(k)s have picked-up and will continue to pick-up enough momentum to become significantly prevalent in 401(k) plans and 403(b) arrangements. The popular press has already brought some attention to this “new” design and will certainly increase focus and publicity once the regulations are finalized.

RPS’ Position

RPS believes that the Roth 401(k) can provide a great opportunity for plan sponsors and an increased benefit to their employees. Although a Roth feature may not be
appropriate for all plans or employees, we encourage our plan sponsor clients to at least explore the concept of Roth contributions.

For those that do choose to add a Roth feature, we will provide the education and recordkeeping support needed to make this type of plan successful.

We are happy to consult with you on the appropriateness of such a design for your plan. Please contact your Plan Specialist directly to begin that dialogue.