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In 1997, the Internal Revenue
Code was amended to permit individuals to make contributions to a new
type of IRA called a "Roth IRA."
Contributions to a Roth IRA are included in an individual’s income
and, unlike distributions from a "traditional" IRA, distributions from a
Roth IRA are not usually taxed. In 2005, an individual may contribute up
to $4,000 ($4,500 if over age 50) to a Roth IRA.
Roth IRAs have become very popular because they allow individuals to
save for their retirement without facing income taxes on their later
withdrawals from their Roth IRAs.
Starting in 2006, the benefits of Roth IRAs will be expanded to
401(k) plans. This new feature is called a "Roth 401(k)."
What is a Roth 401(k)?
A Roth 401(k) is a part of a traditional 401(k) plan.
It allows a participant to make after-tax Roth 401(k) contributions to a
plan and usually allows distribution of the Roth 401(k) contributions
(and earnings) without any further taxation.
Roth 401(k) contributions must comply with all of the requirements
that apply to "traditional" 401(k) plan contributions and, for
distributions to qualify as tax-free, must also comply with a series of
special Roth 401(k) rules.
Benefits of a Roth 401(k)
There are several reasons to consider a Roth 401(k):
Roth IRA Contributions Are Not
Available to Higher Paid Employees but Roth 401(k) Contributions Are
Individuals earning over $110,000 ($160,000, if
married) are not eligible to make Roth IRA contributions. However, Roth
401(k)s are not subject to these income limits. A Roth 401(k) creates a
new opportunity for highly compensated employees and officers to save
for their retirement and receive 401(k) distributions on an "after-tax"
basis.
Reduced Fees for Employees
Employees currently eligible to make Roth IRA
contributions often have small account balances that lead to the
imposition of annual account fees that eat away at their retirement
savings. Roth 401(k) plans may help employees save more for their
retirement without reduction for fees.
Higher Contribution Limits Than Roth
IRAs
Many employees already contribute to Roth IRAs.
However, the dollar limits that apply to Roth 401(k) contributions
($15,000 in 2006) are far greater than the basic Roth IRA contribution
limit ($4,000 in 2006).
Long-Term Compounding for Younger
Employees
Younger employees who will not need their retirement
savings until a date far in the future will be able to pay taxes on
their contributions today and have them grow on a tax-free basis until
their retirement. As a result, earnings on their contributions will
compound over a long period without being taxed in the future. Whether
or not a participant will benefit from a Roth 401(k) will vary on a
participant-by-participant basis.
Special Contribution Rules
There are a number of special rules governing
contributions to a Roth 401(k) account:
Election of Roth 401(k) Contributions
The Roth 401(k) rules require that participants have
the ability to elect between Roth and traditional contributions to their
401(k) plan. A participant must make an irrevocable election whether a
contribution is a traditional, pre-tax contribution or a Roth 401(k)
contribution before an amount is contributed to the 401(k) plan.
Separate Recordkeeping
Roth 401(k) contributions must be tracked separately
from other contributions to a 401(k) plan.
Forfeitures
Forfeitures may not be allocated to Roth 401(k)
accounts.
Allocation of Gains, Losses and
Expenses
Gains, losses and plan expenses must be allocated
between a participant’s Roth 401(k) and other 401(k) accounts on a
reasonable basis.
Rollover Roth 401(k) Contributions
A Roth 401(k) plan may permit a participant to roll
his or her Roth 401(k) accounts in other plans into a 401(k) plan
permitting Roth 401(k) accounts. Separate recordkeeping will be
required.
IRS Contribution Limits
Roth 401(k) contributions are subject to the maximum
contribution limit that applies to traditional, pre-tax contributions.
As a result, in 2006, the maximum combined amount of Roth and pre-tax
contributions will be $15,000 ($20,000 for participants over age 50 if a
plan permits catch-up contributions).
Nondiscrimination Testing
Roth 401(k) contributions are treated like traditional
pre-tax contributions for purposes of applying the Internal Revenue Code
nondiscrimination testing requirements. In addition, a Roth 401(k)
feature must be made available to participants on a nondiscriminatory
basis.
Matching Contributions
Employer matching contributions on Roth 401(k)
contributions may not be made as Roth 401(k) contributions and must
continue to be made on a pre-tax basis.
Special Distribution Rules
There are also a number of special rules governing
distributions from a Roth 401(k) account:
Requirements for Tax-Free Distribution
Roth 401(k) contributions and earnings on these
contributions are only tax free if they are distributed because of a
participant’s reaching age 59½, a participant’s death or a participant
becoming disabled.
In addition, Roth 401(k) contributions may not be distributed
tax-free within five years of a participant’s first Roth 401(k)
contribution to the plan or a predecessor Roth 401(k) plan.
Voluntary Rollover of Roth 401(k)
Distributions
401(k) plans are already required to allow
participants to roll their 401(k) plan distributions over to another
401(k) plan or an IRA. Roth 401(k) contributions will be subject to the
same rules, except that rollover distributions of Roth 401(k)
contributions must be made to another Roth 401(k) or a Roth IRA.
Mandatory Rollover of Involuntary
401(k) Distributions
Since March 28, 2005, plans that automatically cash
out small participant account balances under $5,000 have been forced to
automatically roll over a cashout valued between $1,000 and $5,000 to an
IRA. These mandatory rollover rules also apply to cashed-out Roth 401(k)
accounts valued between $1,000 and $5,000, except that these amounts
will be automatically rolled into a Roth IRA.
Required Minimum Distributions
Unlike Roth IRAs, where distributions do not have to
begin during the Roth IRA owner’s lifetime, Roth 401(k) accounts must be
distributed according to the same minimum required distribution rules
applicable to traditional 401(k) contributions.
Unresolved Issues
Although many of the basic rules governing Roth
401(k)s are clearly addressed by the Internal Revenue Code and existing
IRS guidance, a number of additional open issues are expected to be
addressed by the IRS in coming months. These issues include the
following:
Rollover Contributions From Roth IRAs
Many employers allow employees to roll their regular
IRAs into their 401(k) plan. It is unclear whether a Roth IRA may be
rolled into a Roth 401(k) plan.
Loan Defaults
Many 401(k) plans permit participants to request and
receive loans from their 401(k) plan accounts. If a participant defaults
on his or her loan, he or she is generally subject to income tax on the
amount defaulted.
It is not clear whether a defaulted loan that was
taken (either in whole or in part) from Roth 401(k) contributions will
be taxed as a distribution or whether a defaulted loan may qualify for
the tax-free treatment given to most Roth 401(k) distributions.
Sunset Provision
Aside from issues to be addressed by upcoming IRS
guidance, there is a potential longer-term issue for Roth 401(k)s—the
statutory "sunset" of these plan provisions after 2010. Roth 401(k)s
were added to the Internal Revenue Code in 2001 with a January 1, 2006,
effective date. However, they are due to automatically "sunset" after
2010.
If Congress does not extend or eliminate this sunset, the IRS will
need to issue additional guidance and Roth 401(k) plans will likely need
to be amended again to discontinue future Roth 401(k) contributions.
Impact on Plan Sponsors
Plan sponsors that elect to implement Roth 401(k)
contributions will face a number of additional requirements and
communications issues:
Reporting and Withholding of
Contributions
An employer must report Roth 401(k) contributions on a
participant’s W-2. Also, because Roth 401(k) contributions are taxed,
withholding taxes attributable to Roth 401(k) contributions must be
withheld from a participant’s income.
Communication with Participants
Many employees will be familiar with the concept of
after-tax contributions from their experience with Roth IRAs. However,
for many other employees, Roth 401(k) contributions will be a new
concept that will need to be explained to employees. Clear participant
communications will be essential to avoid confusion among this group of
employees.
Plan sponsors will want to tread carefully to limit
the risk that participants will later assert that they were improperly
directed to Roth 401(k) contributions over traditional, pre-tax
contributions (or vice versa).
Plan Amendments
Employers must amend their plan documents and update
their summary plan descriptions to reflect the Roth 401(k) rules if they
are going to make Roth 401(k) contributions available to their
employees.
Conclusion
Roth 401(k)s are an exciting new feature that may
benefit many employees. Although Roth 401(k)s are not permitted prior to
January 1, 2006, there are a number of design and logistical decisions
that will need to be considered before Roth 401(k) contributions are put
into place.
An employer considering Roth 401(k) contributions should consult with
its advisors and service providers to discuss what changes would need to
be made to its plan document, summary plan description, other plan
materials, service agreements, payroll systems and recordkeeping systems
to implement the Roth 401(k) rules.
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