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What is it?

This is a new type of employee contribution that can be made to a 401(k) plan starting January 1, 2006. These will be after-tax contributions that grow tax-free and that may be exempted from tax upon distribution.

What is the benefit?

Participants may be able to avoid paying tax on the investment income. Next year the maximum contribution limit will be $15,000 for participants who are under age 50 and $20,000 for those who are 50 and older. Assume a participant makes a $20,000 pre-tax contribution and this amount grows to $45,000 by the time it is withdrawn from the plan. The entire $45,000 is taxable.

Assume the participant contributes $20,000 as a Roth 401k contribution instead. Tax must be paid on the $20,000 before it goes into the plan but the invest income may escape tax when the distribution occurs. The ultimate financial impact will depend upon whether a participant’s tax rate is higher at the time contributions are made to the plan or when the distribution occurs. Historically employees have been encouraged to save pre-tax with the expectation they will be in a lower tax bracket when they retire. Concern about future tax increases will cause many to reconsider this bit of provincial wisdom.

Since the Roth Ira was introduced, it has been frequently misconceived as a huge tax break. This misconception comes from the fact that investment income may escape taxation. For example, a $1,000 contribution invested at a 9% return will grow to $13,268 after 30 years. Assuming a 15% tax rate, $1,176.47 must be earned, $176.47 of Federal incomes paid in order to have $1,000 to contribute as a Roth contribution. Paying $176.47 of Federal income tax up front before making the $1,000 contribution is very appealing in exchange for not having to pay tax on the $12,268 investment gain. But with a pre-tax contribution, $1,176.47 can be invested instead of $1,000. This contribution amount will grow to $15,609 after 30 years at a 9% return. Guess what!! Assuming the same 15% tax rate at the time of distribution, $2,341 of taxes must be paid leaving the same $13, 268 after tax. It should also be noted that the $176.47 of pre-tax contributions may be eligible for employer matching contributions. See the attached spreadsheet for additional analysis.

What does this all mean? The Roth contribution doesn’t provide a tax break. The results will be the same if the tax rate at the time of distribution is the same as the participant’s current tax rate. So the most important issue is a participant’s current tax rate versus his tax rate at the time of distribution. This will depend on future tax rates, a participant’s income now versus at retirement, and changes in the government’s tax policy.

Do we have to offer the Roth 401k?

No you do not have to add the Roth 401k feature to you plan but you may want to give your participants this option.

Can participants make both pre-tax and Roth contributions?

Each participant will be able to mix the two types of contributions however he wishes. The contributions may all be pre-tax, all Roth, or some combination of the two. Each participant who wants to make Roth contributions will be required to complete a new enrollment form.

Can the Roth contributions be matched?

The Roth contributions will be eligible to be matched by the employer just like regular pre-tax contributions. The same matching contribution rules of the plan that apply to pre-tax contributions will apply to the Roth contributions. It should be noted that the best option for participants who are contributing less than the maximum amount that is matched by the employer is to increase their contribution rates to the maximum amount that is matched by the employer. It is easier to achieve this with pre-tax contributions than with Roth contributions.

Do the age 70 1⁄2 minimum distribution rules apply to Roth contributions?

The age 70 1⁄2 minimum distribution requirements that require 5% owners who are still employed by the company to take minimum distributions starting at age 70 1⁄2 apply to the Roth contributions. It is unclear at this time whether the minimum distribution rules can be avoided by transferring the Roth money accumulated in the 401(k) plan to a Roth IRA.

Is there an income limit similar to the Roth IRA?

A Roth IRA is not available to high-income individuals and families. Joint filers are ineligible to make Roth IRA contributions when modified adjusted gross income hits $160,000. The limit is $95,000 for single filers. The 401(k) Roth feature can be used by anyone regardless of income.

Are all Roth distributions exempt from tax?

No, the earnings that are distributed will be free of tax only for “qualifying distributions.” A qualifying distribution must be after age 59 1⁄2, for death, or for long term or total disability. A deemed distribution due to a loan default and a hardship withdrawal distribution is not a qualifying distributions. Earnings will be taxable if the Roth contributions are distributed to the participant within 5 taxable years from the first Roth contribution. The year in which the contribution is made counts as an entire year. As a result, any Roth contributions made during 2006 will satisfy the five taxable year requirement as of December 31, 2010.

How are non-qualifying distributions taxed?

IRS has not answered this one yet.

Are Roth contributions subject to non-discrimination testing?

The Roth contributions are subject to the same non-discrimination testing as employee pre-tax contributions unless your plan has adopted a safe harbor design.

May the Roth contributions be withdrawn for a financial hardship?

Yes they may be withdrawn for financial hardships but as noted above such withdrawals are not qualifying withdrawals. Therefore a withdrawal for a financial hardship will result in taxation of the investment earnings.

May the Roth contributions be borrowed?

Yes if your plan permits loans, but as was noted above, the deemed distribution that will occur if the loan isn’t repaid in full will be a non-qualifying distribution.

What are the major risks with Roth 401(k) contributions?

The first is the fact that these contributions will end as of December 31, 2010 unless Congress enacts legislation expending them. It is impossible to predict whether this is likely to happen. In addition, the legislation that made the Roth 401(k) contributions possible does not contain a provision specifying how these contributions and the investment income will be taxed after the Roth provision ends during 2010. As a result, participants who make Roth contributions have no assurance that they will get the intended tax break on the investment earnings. If many participants make Roth contributions prior to 2010, members of Congress will be under substantial political pressure to at least extend the free of tax break to earnings on Roth contributions that are made during the next five years but there in no guarantee this will happen.

Another risk participants face is the fact that the government can change the rules at any time. Congress could for example decide to tax all or a portion of the earnings on the Roth contributions. If you think this is far fetched, consider the following examples.

A substantial portion of Social Security benefits are now taxable to individuals whose incomes exceed specified levels. This changed occurred after decades where Social Security benefits were not subject to taxation.
During the early days of the Clinton administration, a senior Treasury official was pushing hard to tax investment gains in retirement plans. This did not happen but there was lots of concern at the time that it would happen.

The Reagan administration introduced legislation that would have totally eliminated 401(k) during 1985. This effort to kill 401(k) failed only because many participants successfully lobbied members of Congress pressuring them to keep 401(k).

Who should consider Roth contributions?

Roth contributions could be an attractive alternative for younger employees who expect to be in a higher tax bracket in the future and who have lots of years to invest their money. For example, a $5,000 invest will grow to $66,000 in 30 years assuming a 9% investment return. Being able to withdraw $66,000 in 30 years with no tax to pay would be great. But, 30 years is a long period to wait to see whether the government changes the rules.

The Roth contributions could also be beneficial to older participants who are contributing the maximum amount now and can afford to do so as Roth contributions. The maximum contribution for 2006 is $20,000 for participants who are over age 50. Contributing $20,000 during 2006 as Roth contributions will result in a larger benefit, net of taxes, during retirement for the participant because the tax liability has already been satisfied. The entire $20,000 will be available plus the investment income. With a $20,000 pre-tax contribution, only the amount available after paying taxes is available as retirement income. Of course much of this advantage can be duplicated by investing the tax savings that is achieved with a pre-tax contribution outside the plan. See the attached spreadsheet example.

In addition, the extent to which Social Security benefits are subject to tax is tied to taxable income. The participant could get some break by having lower taxable income during retirement.

What is needed to add Roth 401(k) contributions?

Your plan must be amended, new enrollment forms must be provided, your payroll system must be adjusted to handle this new type of contribution, and our record keeping system must separately track these contributions.

Roth Illustrations

Example 1:

Assumes a 15% tax rate during the accumulation and distribution period. This example assumes a participant is currently making a $1,000 pre-tax contribution. It is assumed the participant will increase his annual contribution to $1,176 to match the after-tax cost of making a $1,000 Roth contribution. With a Roth contribution, the participant must earn $1,176.47, pay $176.47 of Federal income tax to have $1,000 left to contribute to the plan. It is further assumed that the $1,176.47 contributed to pre-tax will be invested at a 6% rate for 20 years. The amount accumulated is then withdrawn in a lump sum at a 15% tax rate. It is assumed the Roth contribution is also invested at a 6% rate and the investment income will never be taxed.

Example 2:

Assumes a 33% tax rate for a high income participant who expects to withdraw the money in 5 years and a 33% tax rate at the time of distribution. It is also assumed this participant will contribute the $20,000 maximum during 2006 either as a pre-tax contribution or as a Roth contribution. With the Roth contribution, the participant must pay $9,850 of Federal income tax in order to have $20,000 left to make the Roth contribution. With the pre-tax contribution, it is assumed this $9,850 that will be paid to Uncle Sam with a Roth contribution is invested outside the plan after paying tax on this amount. This will leave $6,600 to invest outside the plan in addition to the $20,000 inside the plan. It is assumed that all invested money earns 6% per year but the $6,600 invested outside the plan is taxable at the 33% rate resulting in a 4.02% after-tax return.