Pension
Trends Volume VI, No. 2, June 2005
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Pension
Trends Volume VI, No. 2, June 2005
Download/view PDF version
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In this issue...
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Roth 401(k) Accounts Are Coming in 2006 -- Are You Ready? Should You Be?
Starting in 2006, 401(k) plans can be amended to allow employees to make “Roth” contributions in addition to or instead of traditional salary deferral contributions. Although there is no requirement that 401(k) plans allow Roth contributions, we expect most will.
Here is a quick overview of how Roth contributions will work:
Roth contributions are made by the employee with after-tax
dollars rather than before-tax dollars like traditional salary deferral
contributions.
The limits that apply to employee salary deferral
contributions will apply to the total of Roth contributions and salary
deferral contributions made by an employee. Adding a Roth contribution feature
to a plan will not increase how much an employee can contribute.
An employee can split his or her contributions between Roth
and traditional salary deferral contributions. For example, an employee may
elect to put 75% of her contributions in as Roth contributions and 25% as
traditional salary deferral contributions.
Similar to a Roth IRA, distributions from a Roth 401(k)
account must meet certain conditions to avoid taxation and/or penalties.
Unlike a Roth IRA, there is no income threshold to qualify to
make Roth contributions to a 401(k) plan. In 2005, a married worker with
income over $160,000 cannot take advantage of a Roth IRA. Starting in 2006,
that same individual could make a Roth contribution to his employer’s 401(k)
plan of $15,000 plus $5,000 catch-up (or a lesser amount if limited by the
plan itself).
Assuming all applicable rules (for example, attainment of age 59½) are met when a Roth 401(k) account balance is distributed, no tax is due. The entire distribution - including investment gains - is nontaxable. Roth 401(k) account balances may also be rolled over to a Roth IRA.
There are no distinctions between traditional and Roth salary deferrals with regard to matching allocations, contribution limits, and nondiscrimination testing. But there are several decisions plan sponsors will need to make with regard to Roth contributions. When and how often may a participant switch his/her allocation between traditional salary deferral contributions and Roth contributions? How are Roth contributions going to be tracked?
Perhaps the most important question is: How are we going to explain all this to employees? It is not a given that an employee is better off with Roth contributions than with traditional 401(k) salary deferral contributions. Until someone knows with certainty what income tax bracket he or she will be in upon retirement, it is impossible to measure the relative advantage, if any, of making Roth contributions versus regular salary deferral contributions. An account that is expected to grow at 20% annually (please have the investment advisor call us!) will benefit more from being a Roth account than one expected to grow at 5%.
For some, the attraction of the Roth account is more emotional than financial: “I know exactly how much I can get out of my Roth account unlike the rest of my 401(k) accounts which are subject to taxation in the future at tax rates I cannot know with certainty today. My financial planning is simpler with the Roth account.”
Adding a Roth feature to a 401(k) plan is not as simple as slapping on a one-page amendment to the plan. Plan sponsors will have to establish administrative procedures and coordinate them with the capabilities of the investment company(ies) and the recordkeeper. New employee communication materials explaining Roth contributions in general and the plan’s new procedures will need to be developed. Employees will need to be given time to make their decisions.
If you or your clients are considering a Roth contribution feature for your 401(k) plan in 2006, now is the time to start.
Have you ever wondered who the friendly voices belong to when you call IAI? They belong to two very valuable and versatile women: Kim Floistad and Terry Mitchell. Kim has been with IAI for four years. She makes multi-tasking look effortless. Terry has been with IAI for three months and has already discovered how much fun working with actuaries can be. They are more than just cogs on the wheel; they keep the wheel on track and rolling along.
This newsletter has been published in order to share general information with our professional contacts. The information presented in this newsletter should not be relied upon without first seeking the advice of a CPA, Attorney or other benefit professional.