The Roth 401 (k) Plan

As of 2006, retirement plan sponsors can add Roth 401(k) features to their retirement plans, allowing plan participants to make after-tax deferrals out of their wages. Unlike conventional 401(k) deferrals, which grow tax deferred until withdrawal, Roth 401(k) deferrals grow tax free, just like amounts saved via Roth IRAs.

This new 401(k) option is a result of Internal Revenue Code Section 402A, a new Code section which was added as part of the Economic Growth and Tax Relief Reconciliation Act of 2001 (“EGTRRA”). Code Section 402A allows participants to designate some or all of their salary deferrals as after-tax Roth contributions, rather than as pre-tax contributions. These Roth contribution provisions may be added to plans by plan amendment effective as of the first plan year beginning on or after January 1, 2006.

Prior to this new provision, Roth IRAs were the only retirement savings vehicle that provided taxpayers with the opportunity to make after-tax contributions that grew tax free. For both Roth IRAs and Roth 401(k)s, tax free growth is only available if the contributions accumulate for at least five years. However, Roth IRAs are subject to two additional restrictions that do not apply to the new Roth 401(k). First, the contribution limitation on Roth IRAs is $4,000 per year ($5,000 if age 50 or older); by contrast, the contribution limitation on Roth 401(k)s is $15,000 per year ($20,000 if age 50 or older). Second, taxpayers with wages over $110,000 per year ($160,000 filing joint) could not make Roth IRA contributions; by contrast, there is no income limitation imposed on Roth 401(k) participants.

In order to make a Roth 401(k) contribution, the participant must irrevocably designate the contribution as “after-tax” prior to the date the contribution is made. The amount contributed is then included in the participant’s wages for that pay period, subject to regular state and federal income taxes, including FICA. A separate plan account must be established to hold the Roth 401(k) contributions. This separate account must continue to be maintained until all of the Roth 401(k) contributions and earnings have been distributed. Roth 401(k) accounts are subject to the same distribution restrictions as apply to pre-tax contributions (i.e., no in-service distributions prior to age 59 ½ unless on account of financial hardship). Unlike Roth IRAs, Roth 401(k) amounts are subject to the required minimum distribution rules that apply beginning when a participant reaches age 70 ½.

In order to implement the new Roth 401(k) provisions, a plan sponsor must amend the plan to incorporate the new provisions. As part of that amendment, the plan sponsor will need to address certain administrative issues that will arise with Roth contributions. For instance, the plan will need to reflect that Roth contributions may be rolled over only to a Roth IRA or to another 401(k) plan maintaining Roth contribution accounts. Depending on plan features, other amendments may be necessary regarding excess deferral contributions, participant loans, and distribution options.

Because the new Roth 401(k) contribution provisions are not required, a plan sponsor will want to carefully evaluate whether or not to add the new provisions. This decision will depend upon whether the Roth 401(k) provisions would be of value to the specific employee demographics of the employer. Because earnings on Roth 401(k) contributions are distributed tax free, it is likely that younger employees who have the possibility of significant build-up of earnings over their career would benefit most from these provisions. The potential benefits should be weighed against the additional administrative requirements, including increased recordkeeping requirements, payroll system adjustments, plan amendment costs, and participant communications.

For more information regarding Roth 401(k) plans, please give Randy a call.