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Retirement plan sponsors have a dizzying array of options available to them as they attempt to create a meaningful benefits package for their participants. One optional feature that may be well worth considering is the Roth 401(k). A Roth 401(k) combines features of a traditional 401(k) with those of a Roth IRA. Like the traditional 401(k), the Roth 401(k) allows participants to make contributions via salary deferrals. However, like a Roth IRA, contributions are made on an after-tax basis and participants may take tax-free distributions at retirement, as long as certain holding requirements are met.
The Roth 401(k) was authorized under the Economic Growth and Tax Relief Reconciliation Act of 2001 ("EGTRRA") and the IRS issued final regulations for Roth 401(k) plans, effective January 3, 2006. The Pension Protection Act of 2006 ("PPA") made the Roth 401(k) permanent by withdrawing the sunset provision that would have eliminated the Roth 401(k) feature by 2011. If interested, plan sponsors have the ability to amend their existing traditional 401(k) plan to offer Roth 401(k) accounts as an additional option for participants.
Plan Requirements
An existing traditional 401(k) plan must make a formal amendment to the plan's documents to allow explicitly for designated Roth 401(k) contributions. Operationally, Roth 401(k) contributions and earnings are maintained in a separate account from the traditional 401(k) contributions and earnings. Plan participants must make an election for a portion or all of their salary deferral contributions to be treated as a contribution to the Roth 401(k) account.
Contributions
Unlike contributions to a traditional 401(k) plan that are made with pre-tax dollars, contributions to a Roth 401(k) plan are made on an after-tax basis. The maximum contribution amount to a Roth 401(k) account is the same maximum as in a traditional 401(k). For the 2009 tax year, federal laws permit a maximum annual contribution of $16,500 ($22,000 for participants age 50 and older), although employers may impose a lower limit. A plan participant may make any combination of Roth and/or traditional 401(k) contributions up to that limit.
Employee Roth contributions are eligible for an employer match, but all matching dollars are allocated to a pre-tax account and are not made as additions to the Roth "account". Also, any forfeiture amounts credited to a plan participant are added to the traditional 401(k) account rather than the Roth 401(k) account.
Tax-free Distributions
Like the assets in the traditional 401(k), Roth 401(k) assets accumulate tax-free. However, unlike the traditional 401(k), qualified distributions may be taken tax- and penalty-free from the Roth 401(k) account. Qualification requires that withdrawals are made after the account holder has attained age 59 ½ (or in the event of death or disability) and that a minimum of five years has elapsed from January 1 of the year of the first contribution to the Roth 401(k) account. If both of these requirements are met, the distributions from the Roth 401(k) account will be tax- and penalty-free. Non-qualified distributions (taken prior to satisfying the qualification requirements) of any investment earnings will be taxable and both contributed amounts and any investment earnings may be subject to the 10% early withdrawal penalty.
Rollovers
After the participant has separated from service, distributions from the Roth 401(k) account may be rolled over into another Roth 401(k) or Roth 403(b) or to a Roth IRA. It is important to note, regarding the 5-year holding period, that while moneys transferred from one Roth 401(k) to another Roth 401(k) carry forward the original holding period start date, distributions rolled into a Roth IRA do not - the five year rule applicable to the Roth IRA will restart as of the date amounts are rolled over from the Roth 401(k). In some cases this may not present a problem because the rules for Roth IRAs allow the IRA owner to withdraw his or her "basis" (i.e., the after-tax amount originally contributed to the Roth 401(k)) tax-free, even in the event of a nonqualified distribution. In the case of a rollover of a qualified distribution, the entire amount of the rollover becomes basis in the Roth IRA and can, therefore, be withdrawn tax-free.
No Eligibility Requirements Based on Income Limits
Any employee eligible to participate in the traditional 401(k) is likewise eligible for the Roth 401(k). Unlike Roth IRAs where single individuals with more than $110,000 in adjusted gross income (married couples who have more than $160,000 in adjusted gross income) are ineligible for contributions, there are no income limitations on participating in the Roth 401(k). For some plan participants, this fact alone may make participation in the Roth 401(k) more attractive; if they are ineligible to participate in a Roth IRA, the Roth 401(k) may be their only option to save for tax-free distributions.
Required Minimum Distributions
Required Minimum Distributions ("RMD") are generally required to be taken annually from assets held in a retirement account, starting when participants reach age 70 ½. One exception to this rule is the Roth IRA, which does not require RMDs. However, the Roth 401(k) account does not share in this exception - generally, RMDs must be taken annually as long as there are assets held in the Roth 401(k) account. If the Roth 401(k) holder rolls his/her Roth 401(k) assets to a Roth IRA after separation from service, the RMD rules will not apply (however, the five year holding period for those assets will restart).
Participant Choice
Your plan participants may find making the traditional versus Roth 401(k) decision difficult. Unfortunately, there is no easy answer. Each individual must attempt to analyze the value of receiving a current income-tax deduction when contributing to a traditional 401(k) versus the benefit of contributing to a Roth 401(k) and having the potential for no taxation on future distributions from the plan. Part of the decision hinges on whether personal income tax rates will rise or fall in the future - not an easy forecast to make.
Many plan participants may elect to split contributions between their traditional 401(k) and a Roth account. If an employee qualifies for a Roth IRA, he or she can make after-tax contributions to the Roth and pre-tax contributions to the traditional 401(k). If not, then the plan participant can split contributions between the traditional and Roth 401(k) options.
Implementing the Roth 401(k)
If you decide that a Roth 401(k) plan may be appropriate for your business, you should speak with your current plan provider about implementing this feature for your plan.
Fareed Siddiq is a Financial Advisor at Morgan Stanley Smith Barney located in Pepper Pike, OH and may be reached (216) 360-4901 or
fareed.siddiq@smithbarney.com
Morgan Stanley Smith Barney LLC and its affiliates do not provide tax or legal advice. To the extent that this material or any attachment concerns tax matters, it is not intended to be used and cannot be used by a taxpayer for the purpose of avoiding penalties that may be imposed by law. Any such taxpayer should seek advice based on the taxpayer's particular circumstances from an independent tax advisor.
© 2009 Morgan Stanley Smith Barney LLC. Member SIPC.