While the Roth 401(k) plan option was enacted back in 2001 and has been available since January 1 of this year, advice over whether to jump on the Roth 401(k) bandwagon remains hard to give.Detailed rules on contributions, operations and distributions for Roth 401(k) plans have been slow in coming. Proposed reliance regulations on contributions weren't released until this past December; reliance regs on distributions weren't out until January.
Suddenly, many tax practitioners are overwhelmed by too much detail on some aspects of the Roth 401(k), rather than not enough. Nevertheless, they remain unsure about how to translate all that information into a basic "go" or "no-go" recommendation for clients. To that end, let's look at some details and draw some conclusions in the process.
The contribution limits for a Roth 401(k) account are the same as pre-tax deferrals under 402(g) for 401(k) and 403(b) plans. For 2006, the limit under 402(g) is $15,000, up from $14,000 for 2005. The limit in 2006 for catch-up contributions for participants age 50 and older is an additional $5,000.
If an excess contribution is made to a Roth account, any subsequent distribution is treated as distributions of the excess deferrals and earnings on the excess deferrals. For those who are able to contribute the maximum amount each year, the wealth able to be accumulated for eventual tax-free distribution in a Roth IRA is dwarfed in comparison with the new Roth 401(k).
While only employers can authorize 401(k) plans to offer the Roth option, only employee contributions get Roth treatment. Designated Roth contributions are limited to a participant's elective deferrals. Employer-matching contributions and non-elective contributions may not be designated as after-tax Roth 401(k) contributions.
Unlike Roth IRAs, Roth 401(k)s have no income limitations. They are available to everyone who is a participant in a 401(k) (or 403(b)) plan that allows the contributions.
High-income earners, therefore, stand to benefit in three ways from Roth 401(k) plans: no income limits on their ability to contribute; the ability to max contributions; and the likelihood that they will be in a higher tax bracket that most retirees because of their invested wealth. Like regular 401(k) plans, however, the Roth option must satisfy various nondiscrimination tests, including the actual deferral percentage and the actual contribution percentage tests.
To be tax-free, contributions must be held in the Roth 401(k) account for at least five years. A contribution in 2006 cannot be distributed before 2011.
The amount also cannot be distributed until the employee turns 59-1/2, dies or becomes disabled.
A qualified distribution would be tax-free, the same as a distribution from a Roth IRA made after five years. The five-year period is measured separately for each separate plan.
Any nonqualified distribution is taxable under Code Section 72(e)(8). A pro rata portion of the account's capital and income is allocated to the distribution.
Example 1. In Year One, Bob invests $2,000 in after-tax dollars in a Roth 401(k) account. After three years, the account is worth $2,500. In Year Four, Bob withdraws $1,000. The withdrawal is not a qualified distribution. The income and investment in the account are allocated pro rata. Bob has $200 of income and $800 return of capital.
The Internal Revenue Service rejected suggestions that the special ordering rules in the Code Section 408A(d) apply to distributions from a Roth 401(k). These rules generally provide that the first distributions from a Roth IRA are a return of contributions and are not included in gross income until all contributions have been returned as basis.
Because of the five-year rule, setting up a Roth 401(k) now and having employees make contributions, even small ones, before the end of 2006 can help lock in their tax savings on later distributions. Distributions from Roth 401(k)s can't get favorable tax treatment until at least one contribution was made by the employee/taxpayer before January 1 of the fourth calendar year prior to the distribution.
Amounts in a Roth 401(k) account can be rolled over into another Roth 401(k) account or into a Roth IRA. A transfer to another 401(k) account can only be made by a direct rollover; funds cannot be paid to the employee. In contrast, a transfer to a Roth IRA can be made by making a distribution to the employee, who recontributes the amount to the IRA. The rollover must be made within 60 days.
If funds are rolled over from a Roth 401(k) account to an existing Roth IRA account, the five-year waiting period for qualified distributions is measured from the time of the first contribution to the IRA account. Once an existing Roth IRA has held any contribution for five years, all distributions from that IRA satisfy the five-year requirement. Amounts rolled over from a Roth account to the IRA also would be treated as qualified distributions when paid from the IRA.
If funds are rolled over from a 401(k) account to a new Roth IRA, the five-year period begins when assets are transferred to the IRA and does not include the period that the assets were held in the Roth 401(k) plan.
If the full amount is not rolled over, the portion that is treated as being rolled over (and therefore not taxable) is allocated first to income earned on the account, then to capital.
Example 2. The same facts apply as in Example 1, except that Bob makes a tax-free rollover of $750 to a Roth IRA. The amount rolled over tax-free is deemed to include $500 of earnings and $250 return of capital. If Bob had rolled over $600, the amount rolled over would include the $500 of earnings and $100 of capital.
The succeeding plan must maintain a separate account for amounts rolled over. Amounts in a Roth 401(k) account must be held separately from other 401(k) or 403(b) accounts.
Saving limited disposable income in a health savings account, if eventually used for medical expenses, appears to offer a better deal than a Roth 401(k) account for those who must make a choice. Contributions to health savings accounts are pre-tax, and are allowed to roll over from year to year, while distributions for medical expenses are tax-free.
If an employee must make the choice between contributing available dollars to an HSA or a Roth 401(k), the HSA appears to win to the extent that funds will be used in significant part for medical expenses.
If HSA account balances are withdrawn for non-medical expenses after retirement, income tax on the distribution is due. In that case, the potential participant choosing between the HSA and the Roth 401(k) account is back to the time-value-of-money analysis in which income tax rates today and those projected at the time of distribution are compared, along with earnings growth.
In that analysis, spreading the risk might suggest having some assets in accounts taxable upon distribution and some in tax-free accounts.
In addition to the HSA enhancements that form an integral part of the administration's FY 2007 budget revenue proposals, the catch-all retirement savings account and the lifetime savings account are once again part of the administration's overall plan for tax simplification and reform. While it is assumed that these new accounts would replace Roth 401(k)s and other retirement accounts, transition rules sometimes only deal out a rough justice when it comes to being fair to all taxpayers.
Overall, Roth 401(k) plans appear to be a good deal, at least for the participant. For employers, the jury is still out on whether administrative costs for offering the Roth 401(k) will bite many sponsors in the back. The growing consensus, however, is that if employees want the Roth 401(k) option, the administrative costs will be adequately covered by the goodwill generated.
For potential participants, a certain "faith in the future" is required, since in the Roth 401(k) environment, tax is being paid on contributions currently with the expectation that a higher overall tax, without use of the Roth 401(k) account, would be paid in the future. Nevertheless, just as crunching the numbers on the benefits of Roth IRAs compared to traditional IRAs favors Roth IRAs in most retirement-savings scenarios, Roth 401(k) accounts also appear to be the better long-range investment.
However, short-term uncertainties, such as emergency financial needs, higher education expenses and pending tax reform, as well as uncertainties surrounding long-term market success and the size of future tax rates, all play a role in the Roth 401(k) decision.
Hedging your bets may work best here - keeping part of the nest egg in tax-deferred accounts and part in after-tax savings that offer tax-free earnings. Especially for those individuals closed out of a Roth IRA either because of income level or participation in an employer-sponsored plan, the ability of finally being able to diversify the tax-structure of their retirement savings by accumulating assets in Roth 401(k)s is a major opportunity that should not be ignored.
George G. Jones, JD, LL.M, is managing editor, and Mark A. Luscombe, JD, LL.M, CPA, is principal analyst, at CCH, a Wolters Kluwer business.
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