The Roth 401(k)

Available in 2006but you should be considering it in 2005.

by Larry Heller

The Roth 401(k) is a new retirement savings option that will be available beginning in 2006. It builds on the concept of the Roth IRA. This new feature, which can be offered alongside a traditional 401(k), is an opportunity for plan sponsors to revisit plan design in 2005 and consider whether a Roth 401(k) provision makes sense for their programs.

 

The Concept

401(k)s will permit participants to make Designated Roth Contributions (DRCs), which are elective deferrals labeled in advance as after-tax contributions taxable in the year they are contributed. DRCs are eligible for tax-deferred, possibly even the tax-exempt, investment earnings discussed below. The IRSs proposed regulations on Roth 401(k)s indicate that DRCs must be included in the elective deferrals subject to the traditional actual deferral percentage nondiscrimination testing of elective deferrals and IRSs annual 402(g) limit ($15,000 in 2006). When made as catch-up contributions by participants over age 50, DRCs would also be included when monitoring the annual catch-up limit ($5,000 in 2006).

 

Tax-Free Distributions

To maintain their tax-exempt status, all DRCs and related investment earnings are subject to distribution restrictions. Qualified distributions can only occur at least five years following the year of the participants first Roth 401(k) contribution to that plan (or a predecessor plan) and after the participant attains age 59 1/2, dies, or becomes disabled. (See chart.)

 

Click chart for larger view.

 

 

Decision Points for Participants

Participants contemplating these contributions need to consider how their tax bracket may change over time. These considerations necessitate personal financial analysis, revisited estate planning, and friendly modeling tools. For example, individuals with low current marginal tax rates are generally better off making Roth 401(k) contributions if their tax rates are anticipated to be higher when they retire. For those whose tax rates are expected to remain constant, the ability to maintain Roth 401(k) accounts tax-exempt status via rollovers will also be appealing.

 

The Impact on Recordkeeping Systems

Given their unique characteristics, DRCs, related investment earnings, and the dates on which participants make these contributions must be distinguished from all other types of contributions by 401(k) plan recordkeeping systems. This impacts the plans administrative process in: the solicitationand confirmation of contribution rates; payroll systems treatment of each type of deduction; year-end IRS tax reporting, mid-year monitoring against IRS limits, and nondiscrimination testing; and any personalized communications of account activity, such as quarterly statements and online information and voice response systems.

 

Are Roth 401(k) accounts right for all employers plans and, if so, should DRC account balances be made available for loans? Will payroll and record systems and plan sponsors be prepared to support the nuances described above, including the communications campaign and plan document revisions needed to introduce them? Will an employers retirement program be at a competitive disadvantage if it does not offer the flexibility of Roth 401(k) contributions? This is an intriguing employee benefit improvement possibility we will have to wait and see.

Posted June 10, 2005 in Engaged Workforce

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