While Congress spends part of this summer continuing the debate on the future of Social Security, employers should take the opportunity to review the advantages of implementing a new retirement savings program that is commonly referred to as Roth 401(k) account. This new retirement savings account may be a boon to both high-income savers and younger workers who wish to save as much as possible and desire the certainty of knowing what their after-tax retirement nest will be.
A Roth 401(k), found in Section 402A of the Internal Revenue Code of 1986, as amended ("Code"), is the statutory sister of a Roth IRA (originally enacted by the Taxpayer Relief Act of 1997). The Roth savings concept is simple. An individual makes after-tax contributions to a retirement account and, provided that the funds are invested for five taxable years, the investment and earnings are distributed tax free. Until the passage of the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), Roth contributions could only be made by those with an adjusted gross income ("AGI") below a certain level ($110,000 for single/head of household individuals and $160,000 for married couples). This meant that high wage earners were excluded from the Roth account savings opportunity.
This retirement accumulation structure is about to change with the Roth 401(k) effective on January 1, 2006. Roth 401(k) accounts can be available to employers who sponsor either traditional 401(k)s or 403(b) plans. On March 2nd, the IRS issued proposed regulations for Roth 401(k)s. This article addresses the basic rules as well as some planning aspects for employers to consider in implementing Roth 401(k) accounts.
Roth 401(k) Basics
The most important feature of a Roth 401(k) is that when employees make after-tax contributions to such an account, the money accumulates tax free. Once the individual reaches age 59 1/2 and presuming the five year investment period (described below) is met, all withdrawals are completely tax free. This is the exact opposite of a traditional 401(k) plan where contributions are made on a pre-tax basis, but distributions are taxed as ordinary income subject to the individual's marginal tax rate at receipt of the distribution.
In essence, this means that the advantage of contributing to a Roth 401(k) account is dependent upon what tax bracket the employee thinks he or she will be in at retirement. For employees who assume a higher (or at least the same) marginal tax rate in the future, the certainty of knowing that the distribution is entirely tax free is significant.
Even for lower income employees who had been eligible to have a Roth IRA, the contribution limits of an IRA versus a Roth 401(k) makes the "(k)" option advantageous. Unlike a Roth IRA, which limits the maximum contribution to eligible individuals to $4,000 in 2006 ($4,500 for employees over age 50), Roth 401(k) contributions are subject to the overall limitation on elective contributions ($15,000 for 2006 and $20,000 if a participant is age 50 and able to make "catch up" contributions). The $15,000/$20,000 total elective contribution limit is a combined limit which applies to both Roth and traditional pre-tax 401(k) contributions. This means that if a company offers both a Roth 401(k) and a regular 401(k), it must be willing to track the two contribution amounts administratively.
In addition to the higher contribution limit, unlike an IRA (Roth or non-IRA), plan administration fees for a Roth 401(k) may be paid by the plan or plan sponsor. This means that contributions may grow without a haircut for administrative costs.
Roth 401(k)s do not provide for Roth employer after-tax matching contributions. If a company makes matching contributions to a Roth 401(k) account, those monies will be taxed as ordinary income when distributed to a participant.
Unlike a Roth IRA, a Roth 401(k) must be established by an employer, not the employee, and that employer must be willing to account separately for the Roth 401(k) contributions (through keeping the contributions in a money source). An employer must also maintain separate records for each Roth 401(k) account. Under IRS proposed regulations, if a Roth 401(k) account is functionally part of a larger plan that also receives regular pre-tax 401(k) contributions, then the Roth 401(k) accounts and non-Roth accounts must be charged and credited with gains, losses and charged on a reasonable basis. This separate accounting and recordkeeping requirement will add another layer of recordkeeping complexity and may add to recordkeeping and compliance costs to companies, but those costs may be outweighed by the tax benefits to employees.
Roth 401(k) contributions are subject to the ERISA non-discrimination rules applicable to 401(k) plans and are, for actual deferral percentage testing purposes, treated as elective, not after tax contributions. When contributions to highly compensated employees need to be reduced because the Code Section 401(k) non-discrimination testing fails, the plan can specify whether Roth 401(k) or pre-tax deferral contributions will be returned first, or can give the choice to participants as to which contributions are refunded first. If a Roth 401(k) contribution is refunded, then the only monies subject to ordinary income tax are the earnings on the Roth contributions.
The distribution rules are basically the same as with traditional 401(k)s. Provided that the Roth contributions have remained in the account for five years, Roth contribution distributions can be made upon severance of employment, hardship, attainment of age 59 1/2, death, disability and plan termination. The five year requirement characterizes the Roth contribution as "qualified" (i.e., not subject to tax) if the distribution is made at least five years after the first Roth 401(k) contribution was made. It does not matter what the amount of the first Roth contribution is; an employee could contribute one dollar in year one and $10,000 in year four and the same five year investment period would apply.
Under the proposed regulations, the five year requirement appears to apply even if the distribution is on account of a participant's retirement. Because this result seems overly strict, it is anticipated that commentators on these proposed rules will ask the IRS to relax this provision.
Amounts in Roth 401(k) accounts may be rolled over to a Roth IRA or to another 401(k) or 403(b) plan that accepts Roth contributions. The IRS proposed regulations do not make clear whether rolled-over Roth accounts must continue to be separately accounted for or can be combined with new Roth contributions. Guidance is also needed on the operation of the five-year rule, particularly when Roth accounts are rolled over; the treatment of automatic rollovers for Roth contributions; and the permissibility of converting existing after-tax contributions to a regular 401(k) plan.
Issues For An Employer To Keep In Mind
Assuming an employer adds a Roth 401(k) account to its current retirement savings platform, the addition will increase the information that must be provided to employees to help them understand the distinctions between two forms of savings: traditional 401(k) contributions versus after-tax Roth contributions. Undoubtedly, employees will clamor for illustrations and education as to the differences between each. This leads to the obvious question as to whether employers (or their service providers) will be considered to be giving "tax advice" if they were to explain the tax aspects of a Roth 401(k) account. Currently, employers provide tax information on retirement distributions in a general and not individual format in accordance with model IRS notice forms.
Another open question is what happens if a company fails to comply with the separate accounting requirement under the proposed rules. What are the consequences to the Roth account and could any adverse consequences affect the overall albantax-qualified status of a 401(k) plan? Presumably, the company could correct the defect through the IRS correction program for tax-qualified plans called the EPCRS.
Employers may be reluctant to immediately adopt a Roth 401(k) because currently Roth contributions to a 401(k) or 403(b) plans expire after 2010. Therefore, unless the sunset provision is lifted by legislation, after 2010, Roth contributions could remain in a plan, but no new Roth contributions could be made after that time. And although Roth savings accounts have generally been well received by legislators, not all are taken with the concept. In fact, in late April, Congressmen Cardin (D-Md.) and Portman (R-Ohio) introduced legislation to repeal Code Section 402A and thereby Roth 401(k)s.
If An Employer Chooses To Implement A Roth 401(k) - What To Do
An employer that decides to implement a Roth 401(k) should consider the following:
Under the right circumstances, a Roth 401(k) could be a positive addition to an employer's retirement platform and received by employees as another employment benefit.
David W. Garland is Co-Chair of the Employment and Labor Department of Sills Cummis Epstein & Gross P.C., with offices in New Jersey and New York. Angela Macropoulos is Of Counsel to the Firm and devotes her practice to employment benefits.