The Roth 401(k) contribution option, even with almost five years of advance warning, is taking a while to catch on.Reports are that fewer than 20 percent of eligible 401(k) plans now have them, with the rest sticking with tried-and-true pre-tax deferral contributions. If field data is accurate, however, this tepid reception is about to change. When employers, especially those also wearing the hat of the highly paid employee, begin to run the numbers, Roth 401(k) accounts are looking very attractive. This view is especially true following the recent release of favorable final regulations on Roth 401(k) contributions.
Since Jan. 1, 2006, employers have been able to offer a new retirement savings option, the Roth 401(k). While the Internal Revenue Service has known about this option ever since it was approved as part of the massive Economic Growth and Tax Relief Reconciliation Act of 2001, the service did not hurry to issue final regulations on Roth 401(k)s until late in the afternoon before the very last business day of 2005.
Although the final regulations reflect the basic structure of the preliminary guidance issued in March 2005, several important changes have been thrown into the mix. In addition, sudden publicity about the Roth 401(k) has caused many advisors to take a fresh look at the opportunities, while at the same time raising questions about when and how the Roth option may be offered in existing 401(k) plans.
Favoring the highly paid
Unlike Roth IRAs, Roth 401(k)s have no adjusted gross income limitations for participants. Roth 401(k)s are available to everyone who is a participant in a 401(k) plan that allows Roth contributions. High-income earners will benefit most from the new plan, since there are no income limits and most primarily want to avoid tax on distributions down the road. Allowable Roth IRA contributions, on the other hand, begin to phase out at modified AGI levels of $150,000 for joint filers, $0 for married filing separately, and $95,000 for others.
Like a Roth IRA, contributions to a Roth 401(k) are made with after-tax funds. Earnings in, and qualified distributions from, a Roth 401(k) are tax-free. The limits on contributions to a Roth 401(k) are the same as for a regular 401(k) plan, and both Roth and non-Roth 401(k) contributions must be combined in testing for this ceiling. In 2006, a participant can make elective deferrals of up to $15,000 ($20,000 for catch-up contributions for participants age 50 or over).
When the Roth option is offered, it must be offered to all regularly eligible 401(k) participants. Like regular 401(k) plans, the Roth option must satisfy various nondiscrimination tests.
The final regs explain how to treat designated Roth contributions in applying the actual deferral percentage, or ADP, and the actual contribution percentage, or ACP, tests. The final regulations allow Roth 401(k)s to work even in businesses in which most everyone is highly compensated.
Further, under these regulations, a plan may permit a highly compensated employee with elective contributions for a year that includes both pre-tax elective contributions and designated Roth contributions to elect whether the excess contributions are to be attributed to pre-tax elective contributions or designated as Roth contributions.
Setting up a Roth 401(k)
While only employers can authorize 401(k) plans to offer the Roth option, only employee-share 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 contributions. A cash or deferred election may be made at any time permitted by the plan. While many 401(k) plans require participants to make a contribution election before the start of the year, the plan may be amended at any time to accommodate a new Roth 401(k) election option. The election, however, cannot apply retroactively.
The election for elective contributions to be Roth-designated must be made irrevocably. However, the irrevocable nature applies only to that portion of elective contributions covered by the election; that is, for compensation covered under the election period. Frequency-of-election rules under Reg. § 1.401(k)-1(e)(2)(ii) apply to elections to make designated Roth contributions.
Therefore, it is up to the plan to specify the frequency of the election (whether annual, quarterly, monthly or even more frequent), with the only restriction being that it must be at least annually.
* Choices. Employees must be presented with a choice. Employers cannot only provide for designated Roth contributions; the arrangement must also offer pre-tax elective contributions. Nevertheless, in a big boost to Roth 401(k)s, the final regulations allow plans to offer automatic enrollment in the Roth 401(k) option.
* Separate accounts. Separate accounts must be maintained for Roth and non-Roth contributions. The separate accounting requirement applies at the time that the designated Roth contribution is contributed to the plan and continues to apply until the account is completely distributed. Separate accounting will create an additional expense for most plans, but one that should not drive the basic decision of whether or not to include the Roth option. While employers may offer to match Roth-designated employee contributions, therefore, the matching contributions must go into the non-Roth account.
* Withholding. Employee-elective contributions that are not included in the employee's gross income are generally not subject to withholding, FICA or FUTA taxes. Final regs, however, require employers to withhold employment taxes on Roth 401(k) contributions.
Distributions
One of the primary advantages of Roth IRAs is that the original owner is not required to take distributions during her lifetime, as the owner of a traditional IRA must. That advantage is not carried through to the Roth 401(k). Required minimum distribution rules apply. Distributions from a Roth 401(k) plan must start on April 1 following the calendar year in which she reaches age 70-1/2 (or retires, if later, if the participant is not a 5 percent owner).
Further complicating ultimate distributions, Roth 401(k) distributions are subject to ordering rules separate from those applicable to Roth IRAs. However, since existing 401(k) accounts may not be converted into Roth accounts through paying current income tax similar to traditional IRA conversions to Roth IRAs, the issue of Roth 401(k) distributions is not expected to surface significantly for at least several years.
The IRS has promised proposed regulations on distributions soon. One technique that practitioners are interested in having the IRS address is the ability to avoid required minimum distribution rules by rolling a Roth 401(k) into a Roth IRA. Existing guidance leaves resolution of this important issue unclear.
Conclusion
Roth 401(k)s are generally a good deal for owner/employees and other highly compensated employees. They do take planning, however, that includes foresight in realizing that the present tax-deferred amounts may cost the employee more later in life, as well as effort in amending existing 401(k) plan documents and properly notifying employees before this opportunity may be realized.
George G. Jones, JD, LL.M, is managing editor, and Mark A. Luscombe, JD, LL.M, CPA, is principal analyst, at CCH, a WoltersKluwer business.
