On December 30, 2005, the U.S. Internal Revenue Service (IRS) issued final regulations providing guidance on designated Roth (Roth 401(k)) contributions under section 402A of the Internal Revenue Code. The basic appeal of Roth 401(k)s is the same as for Roth IRAs—when future qualified distributions are made, they are tax-free, and earnings on the original contributions are tax-free as well.
Although further guidance on Roth 401(k)s is anticipated later this year, plan sponsors may implement Roth 401(k) provisions effective January 1, 2006. Due to extensive press coverage of Roth 401(k)s and strong endorsement of the concept by a number of major investment firms, plan sponsors must be prepared to address Roth 401(k) inquiries and requests from both participants and plan service providers. Despite these developments, plan sponsors should proceed with caution before implementing Roth 401(k) provisions because of a number of practical and legal considerations and uncertainties.
Roth 401(k) contributions are a separate type of employee elective contribution under a 401(k) plan. The regulations are clear that a "Roth-only" 401(k) plan cannot be established; a plan must also provide for pre-tax elective contributions. Roth 401(k) contributions have several unique characteristics:
Internal Revenue Code Limitations for Roth 401(k) Contributions
Although similar in name, Roth IRAs and Roth 401(k)s are different savings vehicles regulated in large part by different rules. Unlike Roth IRAs, Roth 401(k)s are not restricted by federally imposed eligibility rules based on a participant’s personal adjusted gross income, and prior 401(k) contributions cannot be "converted" to Roth 401(k) contributions. Roth 401(k) contributions are subject to the Code section 402(g) limit on contributions, under which the sum of Roth 401(k) and pre-tax elective contributions cannot exceed $15,000 for 2006. They are also subject to the actual deferral percentage (ADP) test in the same manner as pre-tax elective deferrals, and Roth 401(k) contributions count toward the overall Code section 415 limit ($44,000 for 2006). Further, if permitted by a plan, employees age 50 or older may elect to make additional "catch-up" contributions (up to $5,000 for 2006) in the form of Roth 401(k) contributions.
Roth 401(k) accounts present some administrative challenges. Although they are otherwise treated like pre-tax elective deferrals, Roth 401(k) contributions are treated as after-tax contributions for tax purposes. Roth 401(k) contributions and earnings must be separately accounted for in a separate Roth 401(k) account. Although Roth 401(k) contributions may be "matched" by employer contributions, any such matching contributions must be credited to a separate account and cannot be treated as tax-free Roth 401(k) contributions upon distribution. Separately, Roth 401(k) contributions may serve as the basis for a participant loan, but tracking tax basis in loan accounts may be difficult.
Distributions of Roth 401(k) contributions and any related earnings are free from federal income tax provided the distributions are "qualified." Qualified distributions are those made after the participant reaches age 59-1/2 and not made during the five years after the participant first makes a Roth 401(k) contribution. Distributions before age 59-1/2 are presumably subject to split taxation under which the Roth 401(k) contributions would not be taxed, but any earnings would be subject to income tax and an additional 10 percent tax on early distributions under Code section 72(t).
Unlike Roth IRAs, which are not subject to the minimum distribution rules of Code section 401(a)(9), Roth 401(k) contributions are subject to those rules in the same manner as pre-tax elective deferrals. Nevertheless, a terminated participant with a Roth 401(k) account apparently can avoid application of the minimum distribution rules by making a direct rollover to a Roth IRA. Direct rollovers of Roth 401(k) contributions and related earnings may only be made to a Roth IRA or to a designated Roth 401(k) account under another employer’s 401(k) plan.
Pros and Cons
Before adopting Roth 401(k) provisions, plan sponsors should start by considering the key pros and cons of Roth 401(k)s:
Distributions of Roth 401(k) contributions and earnings are tax free, provided distribution is made after age 59-1/2 and is not made during the five years after the participant first makes a Roth 401(k) contribution.
Availability of Roth 401(k) contributions may encourage additional participation.
Addition of Roth 401(k) contributions may be viewed favorably by employees.
It is not clear which employees will benefit from the trade-off of currently taxable contributions in favor of future tax-free distributions. Given the uncertainties of future tax rates and personal tax positions, most participants will likely need expert assistance in deciding whether Roth 401(k) contributions are appropriate. Although administrators will feel pressure to explain the benefits of Roth 401(k) rules, personalized tax assistance is not the type of information that a plan administrator should be providing and there may be significant participant confusion caused as a result.
Roth 401(k) contributions will add additional complexity to a plan and will necessitate changes to the plan, election forms, SPD and other communication materials. Additional service provider fees may also be imposed.
Rollover distributions may be quite complex to administer because Roth 401(k) contributions may only be rolled over to Roth IRAs or other Roth 401(k) accounts whereas the other plan funds may be rolled over to other retirement plans or arrangements.
It is uncertain whether Roth 401(k) contributions will be permitted after 2010, when the legislation that introduced Roth 401(k)s is scheduled to "sunset." If Roth 401(k) contributions are no longer permitted after 2010, plans would still be required to retain and apply the separate accounting and reporting requirements that apply to the "orphaned" contributions.
If Roth 401(k) contribution provisions are implemented for a 401(k) plan, notwithstanding the potential pitfalls, there are a number of practical issues to consider:
Plan trustee/third-party administrator. Prior to any other action, plan sponsors should communicate with the plan’s trustee and third-party administrator to ensure they are set up to accept and report such contributions in separate accounts and to handle requests for distributions and the related tax reporting. A modification to the sponsor’s agreement with service providers may be necessary.
Payroll and human resources (HR) department staff. The plan sponsor’s payroll and human resources departments should be alerted to the possible changes, so they can consider any needed procedural or other changes. Thereafter, but well in advance of the Roth 401(k) implementation date, HR department staff will need to receive training in Roth 401(k) issues, including how to address participant inquiries. A script or a sheet of frequently asked questions (FAQs) may be useful for this purpose. The IRS has published a list of Roth 401(k) FAQs (available at http://www.irs.gov/retirement/article/0,,id=152956,00.html) that may be helpful in this regard.
Plan amendments. The resolutions and amendments to adopt Roth 401(k) contributions under a plan must be finalized no later than the last day of the plan year in which Roth 401(k) contributions are implemented. For example, if Roth 401(k) contributions are permitted beginning March 1, 2006 under a plan with a plan year-end of June 30, the plan sponsor must adopt amendments no later than June 30, 2006. Collectively bargained plans may need to adopt amendments before the year-end deadline if required by the bargaining agreement. The IRS stated in Notice 2005-95 that it intends to issue a sample amendment for Roth 401(k) contributions after publication of the final Roth 401(k) regulations – plan sponsors should be alert for this sample amendment. Separately, the IRS has released sample Roth 401(k) plan language as part of its listing of required modifications and information package (LRM) for use by master or prototype plans. Frequently, LRM language can be useful in drafting individually designed plans and confirming the IRS’s interpretation of a rule.
Participant notification in advance of implementation date. Adding a new contribution type to a plan is a significant change. Thus, consistent with its fiduciary obligations to participants, the plan administrator should notify participants about the Roth 401(k) changes well in advance of the implementation date.
Unanswered questions. A number of administrative questions remain unanswered relating to Roth 401(k)s. The IRS is considering the tax treatment of Roth 401(k) contributions within a qualified plan, particularly with respect to how the tax-free basis in Roth 401(k) contributions is allocated to plan distributions. Guidance on these issues is expected this year. The interplay between Roth 401(k) accounts and employee stock ownership plan (ESOP) rules is also challenging. For example, the tax treatment of employer stock in Roth 401(k) accounts as well as the tax treatment of ESOP dividend distributions is not clear. Separately, it is not clear whether a pass-through of ESOP dividends from a Roth 401(k) account would adversely affect the restriction on distributions from Roth 401(k) accounts for the specified five-year waiting period. In this regard, there are many other questions concerning the application of the five-year waiting period, such as identifying the exact starting date of the period and tracking the five-year period in predecessor plans or merger and acquisition situations.
Additional IRS guidance is expected in 2006 on the taxation of Roth 401(k) distributions. If an employer intends to implement Roth 401(k) contributions this year, it is imperative that it be alert to such guidance.