June 12, 2006
As originally published in Expert Perspective, a Crowe Chizek and Company LLC publication, Winter 2006. All rights reserved.
Since 1998, individuals have had a choice between (a) contributing pre-tax dollars to a traditional individual retirement account (IRA) and paying taxes on the deposits and accumulated earnings upon withdrawal and (b) contributing after-tax dollars to a Roth IRA and never paying taxes on the accumulated earnings. Beginning in 2006, many employees will now face this same decision with regard to contributions to their company’s 401(k) plan.
Effective Jan. 1, 2006, the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) allows employers to incorporate the features of the Roth IRA into their 401(k) or 403(b) plans.
Employers wishing to offer Roth 401(k) provisions to their employees may incorporate those provisions into their existing 401(k) plan through a formal amendment or establish a separate Roth 401(k) plan. Either action is entirely voluntary for employers.
The Roth 401(k) provision will allow plan participants to designate all or some of their own contributions to be treated as after-tax, Roth 401(k) contributions instead of pre-tax salary deferrals. Because of differences in tax treatment upon distribution, Roth 401(k) contributions and earnings must be tracked separately from the traditional 401(k) contributions and earnings.
Employee contributions made to a traditional 401(k) plan are pre-tax dollars, and the full amount of those contributions is deductible to the employer. Employees may contribute up to a statutory limit each year. For 2006, that limit is $15,000 ($20,000 if over age 50, due to catch-up contribution provisions).
Matching Contributions
Employers may, but are not required to, match employee contributions to a traditional 401(k) plan. Any earnings on the employee contributions and employer matching contributions accumulate tax-deferred within a traditional 401(k) plan, but the entire distribution, contributions and earnings, is taxable to the participant at the time it is taken. A 10 percent penalty is generally assessed if the participant takes a distribution prior to age 59½.
In contrast to employee contributions to a traditional 401(k) plan, Roth 401(k) contributions will be after-tax dollars. Roth 401(k) contributions are subject to the same statutory limit as traditional 401(k) contributions and the cumulative total of the two types cannot exceed that limit.
Earnings on Roth 401(k) contributions will grow on a tax-deferred basis and will be not be taxed as long as certain requirements are met. Employer matching contributions on Roth 401(k) contributions are allowed, but they are treated as pre-tax contributions.
Distributions from a Roth 401(k) account will not trigger a taxable event, if the participant taking the distribution has attained age 59½, has died, or has become disabled. In addition to these requirements, a five-year waiting period must pass before tax-free distributions can be made.
The five-year period is measured beginning with the first year Roth 401(k) contributions were made by the participant or, for participants who rolled over a Roth 401(k) account from another plan, the first year Roth 401(k) contribution were made to the prior plan.
No Income Limitations
Unlike Roth IRAs, Roth 401(k)s are not subject to income limitations. Individuals whose adjusted gross income (AGI) exceeds $110,000 and married couples whose AGI exceeds $160,000 are ineligible to make contributions to a Roth IRA. Because of these income limitations, the Roth 401(k) may appeal to high income participants who are not eligible to contribute to a Roth IRA.
The Roth 401(k) also offers higher contribution limits than the Roth IRA. Contributions made to a Roth IRA are limited to $4,000 for 2006 ($5,000 if age 50 or older, due to catch-up contribution provisions), while contributions to a Roth 401(k) are generally limited to $15,000, as outlined above ($20,000 if age 50 or older due to catch-up contribution provisions). Individuals can contribute up to $19,000 in 2006 ($25,000 if age 50 or older, due to catch-up contribution provisions) to a Roth 401(k) and a Roth IRA.
At age 70½, terminated participants must begin receiving required minimum distributions (RMDs) from their Roth 401(k) account; however, participants can avoid the RMD by rolling their Roth 401(k) funds into a Roth IRA. Traditional IRA plans are subject to RMDs; Roth IRAs, however, are not subject to RMDs. A rollover to a traditional IRA does not avoid the RMD requirements.
Sunset Provision
Currently, Roth 401(k) provisions in the Internal Revenue Code are scheduled to sunset in 2010. If these provisions are not extended, no contributions will be permitted to Roth 401(k) accounts on or after Jan. 1, 2011; however, it is expected that funds previously contributed to a Roth 401(k) account will retain the tax status afforded them by EGTRRA.
The Roth 401(k) provisions offer yet another way to save for retirement. These provisions will allow individuals, regardless of their income level, to take advantage of tax-free growth and tax-free distributions. In addition to high-income employees, Roth 401(k) accounts may also appeal to anyone who expects to be in a higher income tax bracket at retirement age.
Individuals should analyze the expected differential in their tax rates both at the time of their contributions and at the time of their expected distributions to determine if a Roth 401(k) is right for them.
The information outlined above is based on current proposed regulations. Final regulations have not yet been issued.
Under U.S. Treasury rules issued in 2005, we must inform you that any advice in this communication to you was not intended or written to be used, and cannot be used, to avoid any government penalties that may be imposed on a taxpayer.
Jaime Schiavone can be reached at 614.280.5251 or [email protected]
Pete Shuler can be reached at 614.280.5208 or [email protected].