 WICHITA, KANSAS Roth 401(k) & Roth 403(b) Plans The Economic Growth and Tax Relief Reconciliation Act of 2001 ("EGTRRA") contains an optional provision that will be available for 401(k) and 403(b) retirement plans effective January 1, 2006. The new provision gives employers with 401(k) and 403(b) plans the opportunity to allow participants to make after-tax Roth elective deferrals under the plan. The current IRS guidance regarding this new option only addresses 401(k) plan issues. Therefore, the balance of this letter will only refer to 401(k) plans, but we expect that the rules for 403(b) plans will essentially be the same. Currently a participant in a 401(k) plan may contribute part of his or her wages to the plan. That contribution, often referred to as a salary deferral, is contributed to the plan on a pre-tax basis. That is, contributions are made without being taxed for federal income tax purposes. The money, once in the plan, is invested and the earnings are not currently subject to income tax within the plan. However, the income tax on the salary deferrals and earnings is only deferred. The salary deferrals along with any earnings on the deferrals must be taxed when they are distributed out of the plan to the participant. The distribution is 100% taxable. In contrast to pre-tax salary deferrals under a 401(k) plan, Roth contributions to a 401(k) plan are made on an after-tax basis. That is, the contributions have already been subject to income tax. The earnings are allowed to accumulate tax free. When a distribution from the Roth account is made, both the contribution and the earnings are paid to the owner tax free if certain requirements discussed below are met. Thus, Roth 401(k) account distributions may be 100% tax free. Roth IRAs (as opposed to the new Roth 401(k) plan accounts) have been available for many years. However, because of the rules concerning Roth IRAs, not everyone has been able to take advantage of them. For example, a taxpayer with a "modified adjusted gross income" of more than $110,000 (more than $160,000 for married filing jointly) is not to make a Roth IRA contribution. In addition, the maximum amount that an individual may contribute to a Roth IRA is limited. For instance, in the current 2005 calendar year an individual age 49 or younger has a $4,000 limit on contributions to IRAs whether they be traditional IRAs, Roth IRAs or a combination of the two. An individual age 50 or older in 2005 may contribute $4,500 to IRAs. The income limitation discussed above has resulted in many people not being able to contribute to a Roth IRA because they have too much income. Those who can contribute to a Roth IRA are limited to a contribution amount that is generally far less than the maximum amount that can be contributed to a 401(k) plan. The law coming into effect January 1, 2006, opens the door to after-tax Roth elective deferrals under a 401(k) plan and may allow individuals to increase, or for the first time be eligible to make, retirement saving contributions on an after-tax Roth basis. ROTH 401(k) Elective Deferrals As stated above, effective January 1, 2006, an employer may elect to include an after-tax Roth 401(k) option as a part of its 401(k) plan. An employer may give its employees the choice of making traditional pre-tax elective deferrals, after-tax Roth 401(k) contributions or a combination of both. There are two main advantages of a Roth 401(k) contribution as opposed to a contribution to a Roth IRA. The first advantage is that the income limits that apply to a Roth IRA do not apply to a Roth 401(k) contribution. Every employee who is a participant in the 401(k) plan will have the opportunity to make Roth 401(k) contributions if the Roth 401(k) option is added to the plan. The second advantage is that the dollar amount that can be contributed on an after-tax basis to a Roth 401(k) is significantly higher than the maximum contribution that may be made to a Roth IRA. The maximum Roth IRA contribution amounts were discussed above. The maximum amount in 2006 that an employee may contribute to a Roth 401(k) (subject to individual plan limitations) is $15,000 for individuals age 49 or younger and $20,000 for those age 50 or above. After 2006, the dollar limitations will be indexed for inflation. IRS Rules Regarding Roth 401(k) Contributions The IRS recently issued proposed regulations to give guidance as to how a Roth 401(k) plan option will operate. The basic point of the regulations is that Roth 401(k) deferrals for the most part will be treated the same as traditional 401(k) plan pre-tax elective deferrals. The same dollar limits will apply to both types of contributions. An employee's pre-tax salary deferrals and after-tax Roth 401(k) contributions will be added together when applying the deferral limitations under the plan. Employers who provide for matching contributions for pre-tax elective deferrals must also match Roth 401(k) contributions on the same basis. Any employer matching contributions on 3 the Roth 401(k) contributions are not taxable to the employee. The IRS' proposed regulations do not deal with issues regarding distributions of Roth 401(k) contributions. Further guidance is expected. However, based solely on the EGTRRA statute, Roth 401(k) contributions will be subject to the same distribution restrictions as pre-tax elective deferrals. In other words, distributions of the Roth 401(k) contributions are only allowed in the event of death, disability, attainment of age 59 1/2, severance of employment, plan termination or hardship. However, the tax consequences may vary depending on the event that triggers the distribution. Distributions of a participant's actual Roth 401(k) contributions (as opposed to earnings on the account) will always be tax free. However, the income portion of a distribution will be tax free only if the distribution is a "qualified distribution." A distribution is "qualified" if it satisfies two requirements. First, the event triggering the distribution must be one of the following: (1) attainment of age 59 1/2; (2) the participant's death; or (3) the participant's disability. The second requirement is that a distribution not be made within five years of when the employee first makes an after-tax Roth 401(k) contribution to the plan. Decisions and Implementation Early indications are that the Roth 401(k) will be very popular. However, there are things that an employer will need to consider before adding the Roth 401(k) option to its plan. Plans must be amended to implement the addition of the Roth 401(k) option. The IRS has not yet provided any guidance as to when that amendment must be made, but we expect such guidance before the end of the calendar year. If an employer chooses to add a Roth 401(k) option, the employer will need to make decisions such as when to start allowing Roth deferrals and how often to allow participants to make changes to their deferral elections. Plans will need to provide separate accounting for aftertax Roth 401(k) and traditional pre-tax salary deferrals. A Roth 401(k) option will also likely require changes to the employer's payroll systems. An employer will want to talk with its plan record keeper and payroll personnel to make sure they can properly coordinate information and to make sure that payroll systems can handle both pre-tax and after-tax contributions. The change will also need to be communicated to the employees. This information is just a summary of the Roth 401(k) option. If you have any particular questions or comments regarding the Roth 401(k) option, please feel free to contact R. Chris Robe or Hellen L. Haag. The foregoing article has been prepared by Bever Dye, LC, as a service to our clients for informational purposes only and does not constitute legal advice. It is designed to provide general information concerning recent developments and topics of interest in the areas of tax and estate planning law. Do not take action in reliance on items contained in this article without obtaining the advice of an attorney. |