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

 

The Roth option is attractive to young employees or those currently in lower tax brackets because it allows the money to grow tax-free until retirement.  Compared to the traditional 401(k) whose earnings are all taxed, the opportunity for long-term tax-free growth is very advantageous for an employee with several years left before retirement.  Likewise, an employee who is just starting out, is currently in a lower paying position, or who has substantial deductions already and therefore does not have much tax liability, but who anticipates being in a higher tax bracket by retirement, may benefit more from the tax free distributions offered by a Roth 401(k) than he or she would from the current tax reduction of a traditional 401(k).  The other group that may be especially interested in the Roth 401(k) is highly compensated employees who do not anticipate having a decrease in income once they reach retirement age.  These individuals can take advantage of today’s historically low tax rates by paying the taxes on their money up front rather than paying tax – possibly at a much higher rate – once they are ready to withdraw the money.

 

While the Roth 401(k) offers many attractive benefits, there are also a couple of concerns that employers should be aware of prior to implementing a Roth 401(k).  One potential consequence of adding a Roth option to a 401(k) plan comes from the fact that the employee’s Roth designated contribution is from post-tax dollars. An employee who switches his or her contribution from a traditional 401(k) to a Roth 401(k) is going to have an increase in taxable income because his or her 401(k) contribution is no longer taken out pre-tax.  In turn, the increased taxable income will mean an increase in tax which must be paid.  The end result will be a decrease in take-home pay.  In order to maintain the same level of take-home pay, the employee may lower his or her 401(k) contribution. Because this is more likely to be an issue for non-highly compensated employees than for highly compensated employees, the decrease in contributions by non-highly compensated employees may cause non-discrimination test failures.

 

Of course, rather than lowering contributions in order to maintain the same level of take-home pay, participants may simply forgo the Roth 401(k) in favor of staying with the traditional, pre-tax contributions. However, regardless of whether the plan has multiple participants or only a single participant who chooses to contribute to the Roth 401(k), the plan must be amended, and the summary plan description and distribution forms updated in order to offer the Roth option. Additionally, an accounting system to track and separately maintain Roth accounts is necessary, as is a procedure for reporting the Roth deferrals and withholding amounts. Many plan sponsors may find this too much of a hassle – not to mention expense – if the option will only be utilized by a few employees.

 

The authorization for Roth 401(k) is currently set to expire at the end of 2010.  Congress could extend the Roth 401(k) option past that date. Even if it does not, the money already contributed will most likely be allowed to remain in the participant’s Roth 401(k) account until retirement. However, because of the potential temporary nature of the Roth 401(k) Employer should be mindful of the potential temporary nature of the Roth 401(k).  An employer who is interested in adding this option, should do so sooner rather than later in order to offer the most benefit to employees interested in taking advantage of the Roth option.  Offering a Roth 401(k) option along with the traditional 401(k) is definitely something for employers to consider.  If you have questions, or would like to amend your plan to include a Roth option, contact Carla Heathershaw Risko at 342-1000.

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