Employers are gearing-up
to sponsor a new retirement savings option: designated
Roth contributions to 401(k) plans. Starting next year,
employees will be able to designate all or part of their
contributions to their 401(k)s on an after-tax basis.
The change will make most distributions tax free.
Although the change will mean more complexity for
employers, most are expected to offer the option because
of the big benefit that workers can enjoy from tax-free
buildup in their 401(k)s.
Background
Four years ago,
Congress changed the 401(k) rules. It saw that Roth IRAs
were very popular. Many people prefer to save for
retirement through a Roth IRA rather than a traditional
IRA. Although Roth IRA contributions are not
deductible, interest, dividends and appreciation accrue
tax-free. Congress wanted to give a similar savings
choice to participants in 401(k) plans.
Beginning in 2006,
401(k)s can incorporate a "qualified Roth contribution
program." Employees can elect to have all or a portion
of their 401(k) contributions designated as "Roth
contributions." Similar to Roth IRAs, earnings would
grow tax-free and would be free from tax when withdrawn.
Participants in 403(b)
plans, employees of educational institutions and
non-profits, can also take advantage of the new rules.
However, individuals with 457 plans, mostly government
workers, cannot participate.
New rules
Last month, the IRS
issued proposed rules for Roth 401(k) contributions. The
rules are complex. Very broadly, there are three general
characteristics of Roth contributions:
-
Employees must make an irrevocable designation of a
Roth contribution when they make the 401(k)
election;
-
Employers must treat the contributions as included
in the employee's gross income for the purposes of
all taxes, as if the employee had received cash
instead; and
-
Contributions must be maintained in a separate
account.
Designated Roth
contributions are limited to elective contributions.
Employer-matching contributions and nonelective
contributions are not eligible.
There are important
limits on how much an employee can contribute to a Roth
401(k) account. For 2006, the maximum for 401(k)
contributions, whether allocated to the regular or the
Roth portion of the account, will be $15,000. That
figure will be adjusted for inflation for future years.
Getting ready
Employers should start
preparing for the new option. Congress imposed some
strict accounting and recordkeeping for Roth
contributions.
A separate "designated
Roth account" must be established for each participating
employee. This separate account will hold the employee's
designated Roth contributions and earnings allocable to
the contributions. Separate recordkeeping must be
maintained for each designated Roth account.
Many employers
currently sponsoring 401(k) plans establish a trust to
hold and invest employee contributions and for making
distributions. A trust may be an effective option for
administering Roth contributions.
Employee questions
Employees are also
going to have a lot of questions about Roth accounts.
One way to explain the new accounts is to compare them
to Roth IRAs and how a person goes about converting a
regular IRA into a Roth IRA. Employees should consider
the:
- Cost of
the tax benefit of a pre-tax contribution
- Assumed
rate of return within the designated Roth account
- Length
of time until distributions occur
-
Anticipated tax rate at time of distribution
Give us a call if you
would like to learn more about this.
