Within the new reality of date-sensitive tax legislation, practitioners must not only be attentive to sunset provisions for the many tax benefits now granted by Congress - they also need to keep a calendar marked for benefits that phase in or start on a time-delayed basis. In the latter category, one of the more extreme examples is about to hit potentially millions of businesses and tax-exempt employers.
Roth 401(k) and 403(b) plan programs, born within the Economic Growth and Tax Relief Reconciliation Act of 2001 but subject to almost a five-year delay - until 2006 - are about to become a reality.
What steps should be taken now to prepare for the 2006 start date for qualified Roth contribution programs to both 401(k) and 403(b) plans? Are they worth considering from the employer's perspective? For employees, how do they differ from the decision-making involved in selecting a Roth IRA over a traditional IRA?
This article attempts to suggest some preliminary answers.
New Code Section 402A
Effective for tax years beginning after Dec. 31, 2005, 401(k) plans and 403(b) plans can incorporate a "qualified Roth contribution program," under which participants may elect to have all or a portion of their elective deferrals designated as after-tax "Roth contributions." Employer contributions, including matching contributions, cannot be added to the Roth account.
Qualified distributions from such Roth sub-accounts will not be subject to tax, and earnings on the contributed amounts will also grow tax free. However, they continue to be subject to normal plan withdrawal restrictions that require a five-year holding period, as well as reaching age 59-1/2, dying or becoming disabled.
Employee considerations
Many practitioners are predicting a frenzy of activity to start qualified Roth contribution programs within 401(k) and 403(b) plans, even greater than what took place when Roth IRAs first broke onto the scene in 1998, due to the greater number of eligible participants.
Not only have most 401(k) plan participants been foreclosed from opening IRAs of any kind, but many taxpayers who would otherwise be able to open a Roth IRA account cannot do so because their adjusted gross income exceeds the statutory ceiling set for these accounts ($95,000 for singles, $150,000 for joint filers).
* High-income taxpayers. Unlike with Roth IRAs, there is no income cap on participating in a Roth 401(k) or 403(b). For the first time ever, high-income taxpayers can participate in an after-tax Roth contribution plan. The only tricky limitation comes from the plan's perspective, by making sure that it does not fail the actual deferral percentage nondiscrimination test. Highly compensated employees will also be subject to contribution limits based on the actual deferral percentage of other employees, and excess contributions must be returned.
Also of great advantage to all participating employees is the fact that the maximum contribution level to 401(k) plans is $15,000 in 2006, compared to $4,000 for IRAs. Those who can maximize Roth 401(k) participation, therefore, can benefit almost four times as much as they would under the Roth IRA limitations.
* Lower-paid employees. Those employees who are also able to participate in separate Roth IRAs generally do not have an excess amount of disposable income. Eligible participants in a 401(k) plan cannot contribute to a Roth IRA in any year in which their adjusted gross income exceeds $50,000 for single filers ($75,000 for those filing jointly).
Employees who are able to do so, however, should balance their contributions to their 401(k)s by first maximizing contributions to their Roth IRA account and then using the balance of their Code Section 402(g) limit of $15,000 on the Roth contribution and designating any excess as a regular pre-tax 401(k) contribution. Otherwise, if the full $15,000 were designated as a Roth 401(k) contribution, none would be available for the Roth IRA.
Factors similar to the decision to contribute to a Roth or traditional IRA also should be considered in deciding whether to make a qualified Roth contribution. The period of time that the contribution will remain in the account, the age of the taxpayer and the need to make withdrawals, and the anticipated tax bracket of the taxpayer when the funds are needed all factor in to the initial decision.
Employer considerations
Since it is the government, rather than the employer, that pays for any tax benefits gained by designating Roth contributions to 401(k) plans, the option to amend a plan to permit Roth contributions generally will present another inexpensive way to provide an employee benefit at a relatively low cost.
One recent survey reported that over 35 percent of all 401(k) plans are likely to adopt a "qualified Roth contribution program." While certainly some of the 65 percent who don't may have a variety of reasons, the most likely cause for nonparticipation would appear to be simple intransigence, combined with a reluctance to incur additional fees for plan amendment and administration.
In addition, of course, some plans will hold back just so that other plans can "debug" the rules for a year or two. Mistakes in administering the Roth accounts may create significant liability for the employer.
In early March, the Internal Revenue Service issued proposed regulations on designated Roth contributions to 401(k) plans. The IRS said that it was issuing rules now to give employers ample time to amend their plans. The comment period on the proposed regs ends on May 31, and the IRS expects to issue final regulations by mid-summer. No plan sponsor is forced to amend its plan, but no employee may elect after-tax Roth contributions without that amendment.
The proposed regs describe three principal characteristics of Roth contributions:
1. The employee must make an irrevocable designation of a Roth contribution when she makes the cash or deferred election each year.
2. Contributions must be treated by the employer as includible in the employee's gross income for the purpose of all taxes, as if the employee had received cash instead.
3. Roth contributions must be maintained by the plan in a separate account.
Separate accounting rules require that contributions be credited and debited to a designated account maintained for the employee. The plan must maintain records of undistributed Roth contributions for each account and credits and charges must be separately allocated on a reasonable and consistent basis to the Roth and other accounts. The separate accounting requirement would be in force until all Roth contributions had been distributed.
The IRS is asking for comments on the separate accounting rule in hope of reaching a more simplified system in final regs. As already noted, however, some plan administrators currently consider the liabilities and expense of compliance too great to jump into the Roth program immediately in 2006. They would rather wait for the rules to iron themselves out.
The long term
Change seems to come so quickly these days that some practitioners are asking, "Why bother?" to amending 401(k) or 403(b) plans immediately for 2006. In addition to the unknown liabilities of trying something new, the long term may not favor immediate action. All EGTRRA benefits, including Roth 401(k) and 403(b) programs, end after 2010 due to sunset provisions. Perhaps even more immediate is the push by the Bush administration for tax reform. With either sweeping tax reform under a radically revised system, or incremental tax reform based on the administration's preference for eliminating all tax on savings, pre- and after-tax retirement savings plans may become irrelevant.
Conclusion
While practitioners have been waiting almost five years for Roth 401(k)s to become effective, they may wish to wait a bit longer. Once final regulations on qualified Roth contributions are released this summer, both employers and employees will have better information on which to base a decision on whether Roth contributions are a good deal.
In the meantime, if the IRS wants this provision to work, it perhaps must make more of an effort, within the framework of the final regulations, to streamline and simplify the rules and limit employer liability.
