Beginning in 2006, employers with 401(k) plans may revise their plans to allow participating employees to designate some or all of their employee contributions as after-tax "Roth" contributions instead of traditional pre-tax contributions. This revision has been referred to as the Roth 401(k).
The new Roth 401(k) is modeled after the Roth IRA, which was introduced in 1998. Although there is no deduction up front, future distributions of the contributions plus appreciation and earnings will be free from tax assuming certain requirements are satisfied (generally, the distributions occurs after age 59?).
The Roth 401(k) provides key advantages over the Roth IRA, because it does not impose an income limitation on eligible participants and it allows participants to contribute more money to a Roth account than the Roth IRA rules permit.
For example, in 2006 the maximum annual Roth 401(k) contribution is $15,000 ($20,000 if 50 years old by the end of the year), while the maximum Roth IRA contribution is $4,000 ($5,000 if 50 years old by the end of the year).
So, a participant age 54 with wages of $300,000 could contribute $20,000 of his wages to the Roth 401(k). However, his income would be too high to make a Roth IRA contribution.
The benefit of the new Roth 401(k) feature to employers is solely the additional flexibility it provides to plan participants, particularly shareholder and related party employees.
A drawback is the initial cost of amending the plan document and notifying participants. Also, it is likely ongoing payroll and 401(k) recordkeeping expenses will increase as employers will need to account for Roth 401(k) contributions and related earnings separately from other plan contributions.
Finally, the Roth provisions are set to expire under current law as of Dec. 31, 2010. While it is likely that Congress will extend/eliminate this deadline, this is by no means a certainty.
Assuming an employer decides to add the Roth feature, employees will need to determine whether or not it is beneficial to designate some or all of their contribution s as post-tax Roth contributions. As part of that determination, participants must understand that the Roth contribution will be made with "after-tax" dollars.
As an example, a participant in the 25 percent tax bracket who contributes $10,000 of her wages to her Roth 401(k) will also have to pay $2,500 of income tax. In contrast, if she had contributed $10,000 to a traditional 401(k), she would have saved $2,500 in current year’s taxes.
Given the previous example, the participant would be wise to designate post-tax Roth contributions, if she determined that over time the benefits of tax-free distributions would outweigh the current tax cost. Various software calculators are available to help in the analysis of pre- versus post-tax contributions based upon a number of variables, including current and future tax brackets, rates of return, and annual contributions, among others.
In general, the Roth 401(k) may be beneficial if a participant determines that her tax bracket in retirement years will be much higher than the current year’s bracket.
Other participants who may want to pursue the Roth 401(k) route are those people who are willing to pay some tax now to ensure tax-free distributions in retirement years. Similarly, high net worth individuals with significant existing retirement account balances may previously have thought twice about contributing additional amounts to their 401(k) accounts given potential future exposure to both estate and income tax.
Although the Roth 401(k) accounts will still be subject to estate tax, they will not be subject to income tax. Another potential benefit of Roth 401(k) accounts to high net worth individuals is that, upon retirement, they could roll the Roth 401(k) portion of their account balance to a Roth IRA, which has no minimum required distributions during the lifetime of the Roth IRA account holder.
On the other hand, participants must generally begin distributions from regular 401(k) accounts no later than the April 1 of the year following the year the participant attains age 70?.
In summary, employers may amend their 401(k) plans to add after-tax Roth contributions beginning in 2006. Employers will need to determine if the benefits to the participants is worth the added administrative expense, especially in light of the possible disallowance of Roth contributions beginning in 2011.
If the employers decide to add the Roth 401(k) feature, then the employee participants will need to determine if the future benefit of tax-free distributions is worth the income tax paid in the current year on the contributed amounts.
Andrew Komisar, CPA, JD, is an accountant at Komisar Brady & Co. LLP in Milwaukee.
Roth 401(k) Highlights
• Beginning Jan. 1, 2006, Roth 401(k) contributions can be made, if employers decide to offer the plans to their
employees.
• The Roth 401(k) is modeled after Roth IRA. After-tax contributions plus appreciation and earnings will be free from taxes on distributions after age 59.
• The Roth 401(k) provides employees with greater flexibility.
• Employers interested in establishing a Roth 401(k) should be aware of some drawbacks, including additional costs for plan administration.
• Employees may benefit from
participating in a Roth 401(k) if they expect to be in a higher tax bracket in retirement years or other reasons.
