Effective January 1, 2006, plan sponsors can amend their plans and allow participants to make 401(k) contributions on an after tax basis, which will be known as Roth 401(k) contributions. Plan sponsors who amend their plans to permit Roth 401(k) contributions will allow their participants to make 401(k) contributions on either a before or after tax basis. Those participants who elect to make Roth 401(k) contributions will pay federal and state taxes on the contributions. Participants will then be able to withdraw the Roth 401(k) contributions plus investment earnings without being subject to taxation provided they meet the Plan and Roth 401(k) distribution requirements.

Created by the Economic Growth and Tax Relief Reconciliation Act of 2001, Roth 401(k) contributions will be subject to the annual Internal Revenue Code (IRC) Section 402(g) limit, which for 2006 is $15,000 plus an additional $5,000 catch-up contribution for participants who have or will attain the age of 50 during the plan year. In addition, Roth 401(k) contributions will be subject to the overall limitations on annual additions under IRC Section 415(c), which for 2006 is the lesser of $44,000 or 100% of compensation. The Roth 401(k) contributions are currently set up to sunset, or expire, in 2010. To date the IRS has not yet issued guidance on the Roth amendment process.

Separate Accounting:
Under the proposed regulations plan sponsors are required to segregate Roth 401(k) contributions and account for them separately at all times until the Roth 401(k) account is distributed. Forfeitures may not be allocated to the designated Roth 401(k) account. Investment and payroll companies are gearing up to add Roth 401(k) accounts to their existing systems.

Distribution of participant accounts will be affected by the separate accounting requirement. Roth 401(k) contributions can only be rolled over into another qualified plan if that plan provides for Roth 401(k) contributions. Roth 401(k) contributions that are being rolled into an IRA must be rolled into a Roth IRA. If a participant is rolling both 401(k) and Roth 401(k) contributions into an IRA, he must set up a traditional IRA for the 401(k) contributions and a Roth IRA for the Roth 401(k) contributions.

Distributions:
Roth 401(k) contributions are subject to the plan distribution and hardship rules. Distributions of Roth 401(k) contributions will be considered taxable unless the distribution is a Qualifying Distribution. In order for a distribution of Roth 401(k) contributions to be considered a Qualifying Distribution and tax free, it must be made:

(1) after attainment of age 59 ½, or
(2) payable to a beneficiary after the death of the participant, or
(3) upon disability.

In addition, a distribution of Roth 401(k) contributions will only be considered a Qualifying Distribution after five taxable years beginning in the year of the original Roth contribution. The original Roth contribution could have been made to the plan, or to a Roth IRA that was rolled into the plan. Tracking the five year period should be done by the plan sponsor and the participant.

Ultimately, the participant will want to keep track of these holding periods and should be able to do so easily by retaining copies of the W-2 or 1040 from their first year of Roth participation. Upon termination of employment participants can elect to rollover their Roth 401(k) accounts into a Roth IRA and maintain the Roth status on the account.

Nondiscrimination Testing:
Roth 401(k) contributions are included in the nondiscrimination testing with 401(k) contributions.

If a plan fails the test and refunds are chosen as a method to pass the test, a highly compensated employee with both 401(k) and Roth 401(k) contributions may elect the money type from which to receive a corrective distribution. Distributed 401(k) contributions plus earnings would be includable in income. Distributed Roth 401(k) contributions would not be includable in income, though earnings on the contributions would be includable in income because a corrective distribution does not constitute a Qualified Distribution.

Roth 401(k) Contributions Compared to Roth IRA Contributions:
Roth 401(k) contributions are not subject to the income limitations applicable to Roth IRA (currently $160,000 in adjusted gross income (AGI) for married couples and $110,000 for single persons).

Individuals with income above these amounts are disqualified from making Roth IRA contributions. Individuals earning less than the current Roth IRA AGI will be able to contribute to both a Roth 401(k) Plan and Roth IRA. Distributions from Roth 401(k) contributions do not qualify for first time home purchases as distributions from Roth IRAs currently do. Current contributions in 401(k) accounts cannot be converted to Roth 401(k) contributions.

Are Roth 401(k) Contributions Beneficial?
Whether Roth 401(k) contributions are beneficial depends on each person’s individual circumstance.

The question comes down to taxes. Do you anticipate being in a higher tax bracket now, when you make contributions to your retirement plan, or later, when you withdraw money from the plan? Your answers to this question will determine if Roth contributions are beneficial to you. Consider three scenarios:

Scenarios 1 & 2:
If you are in a 25% tax bracket today and you put $1,000 into Roth 401(k) contributions, you will pay $250 in taxes now and invest $750. If your $750 grows at 4% for 10 years, you will then have $1,110.18 of tax free money.

Scenario 1: Low Tax Bracket Now - Higher Tax Bracket Later
If you will be in a 28% tax bracket later and you put $1,000 into 401(k) contributions, you will pay $0.00 in taxes now and invest $1,000. If your $1,000 grows at 4% for 10 years, you will then have $1,480.24 of taxable money. You will then pay $414.47 in taxes and have $1,065.78 in your pocket.

Scenario 2: Any Tax Bracket Now - Same Tax Bracket Later
If you will be in a 25% tax bracket later and you put $1,000 into 401(k) contributions, you will pay $0.00 in taxes now and invest $1,000. If your $1,000 grows at 4% for 10 years, you will then have $1,480.24 of taxable money. You will then pay $370.06 in taxes and have $1,110.18 in your pocket.

Scenario 3: High Tax Bracket Now - Lower Tax Bracket Later
If you are in a 28% tax bracket today and you put $1,000 into Roth 401(k) contributions, you will pay $280 in taxes now and invest $720. If your $720 grows at 4% for 10 years, you will then have $1,065.78 of tax free money. If you will be in a 25% tax bracket later and you put $1,000 into 401(k) contributions, you will pay $0.00 in taxes now and invested $1,000. If your $1,000 grows at 4% for 10 years, you will then have $1,480.24 of taxable money. You will then pay $370.06 in taxes and have $1,110.18 in your pocket.

Note: The above example is simplified for demonstration purposes; taxes are actually paid on a graduated scale; the scenarios assume you withdraw all monies in one lump sum. Please consult your tax advisor for more specific analysis.

As the IRS clarifies Roth 401(k) contribution rules, Administrative Retirement Services, Inc. (ARS) will keep you informed. If you would like to discuss Roth 401(k) contributions, please contact ARS.