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The Roth 401(k) — A New Option for Retirement Savings By Carla Heathershaw Risko

 

The much talked about Roth 401(k) is here. The Economic Growth and Tax Relief Reconciliation Act of 2001 provided for the Roth 401(k) beginning in plan years starting on or after January 1, 2006. The designated Roth 401(k) is not a new type of retirement plan, but rather a new type of contribution that can be allowed by a new or existing 401(k).  If a plan adopts the Roth feature, participants will be allowed to designate some or all of their elective contributions as designated Roth contributions. Unlike traditional 401(k) contributions, which are made with pre-tax dollars, the Roth designated contributions are includable in the participant’s gross income at the time the contribution is made. However, a qualified distribution from a Roth designated account is excludible from gross income.

 

In late December, the IRS and Treasury released a new regulation effective January 1, 2006, to provide guidance on the Roth 401(k).  Employers may now begin permitting Roth designated contributions; the plan, however, must be properly amended by the end of the plan year – December 31, 2006, for plans based on a calendar year; earlier for plans based on a non-calendar year.  As noted above, the Roth feature may be applied to a new or an existing 401(k) plan.  Therefore, if an employer who currently sponsors a traditional 401(k) and wishes to also offer participants the option of making after-tax Roth designated contributions, the plan sponsor may do so by amending the current plan. It is important to note that a plan may include the traditional pre-tax contribution option only or may offer participants both traditional and Roth options, but a plan cannot offer only the Roth contribution option. The participant, however, can designate his or her entire contribution as a Roth contribution. But once a participant designates a contribution as a post-tax Roth contribution, the election is irrevocable and he or she cannot later ask for the contribution to be re-designated as a pre-tax contribution.

 

If the plan allows Roth designations it must segregate the Roth designated contributions from the traditional, pre-tax contributions.  This means maintaining the Roth contributions in a separate account and separately tracking distributions, gains, losses and other changes or credits. The plan may not allocate forfeitures to a Roth account. Employers may make matching contributions based on a participant’s Roth contributions, but such matches may not be treated as post-tax Roth contributions or allocated to a Roth account. Instead, the employer’s matching contribution must continue to be allocated to a traditional pre-tax account even if the participant’s entire contribution goes to a Roth account.

 

Other than the tax treatment of contributions and distributions, the Roth 401(k) is treated very comparably to a traditional 401(k). Whether the participant makes contributions solely to a Roth account or divides his or her contribution between a Roth account and a traditional account, the amount of the participant’s total contribution is subject to the limits of 402(g). ($15,000 for 2006 plus an additional $5,000 catch up if the participant is age 50 or older.) The plan’s restrictions on withdrawals apply to distributions from a Roth account and a participant may be subject to penalties – including taxation of earnings – in the event funds are prematurely withdrawn from the Roth account. Likewise, a Roth 401(k) account is subject to required minimum distributions when the participant reaches age 70 ½ .

 

Additionally, employers are still required to adhere to nondiscrimination testing requirements. Designated Roth contributions must be included in the testing. If it is necessary to make a corrective distribution – for example, due to an ADP test failure – the plan may allow the participant to choose whether the distribution comes from his or her traditional account or Roth account. Because a corrected distribution is not a qualified distribution, the earnings on a returned Roth contribution are taxable (the contribution itself is not, since it was made from post-tax dollars). In lieu of giving the participant this choice, the plan may designate from which account the corrective distribution will be taken.

 

 

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