- An Introduction to Roth 401(k) Plans
- August 23, 2005 | Authors: Richard L. Menson; Jennifer A. Stojak; Jeffrey R. Capwell; Steven D. Kittrell; Robert M. Cipolla
- Law Firms: McGuireWoods LLP - Chicago Office ; McGuireWoods LLP - Charlotte Office ; McGuireWoods LLP - Washington Office ; McGuireWoods LLP - Richmond Office
Employers are increasingly relying on 401(k) plans to provide employees with retirement savings and income, contributing to a dynamic 401(k) plan system. Congress responded to this trend with the establishment of Roth 401(k) contribution programs, which were added to the Internal Revenue Code ("Code") as part of the Economic and Tax Relief Reconciliation Act ("EGTRAA"). The rules for Roth 401(k) programs are set forth in new Code Section 402A.
The Roth contribution program becomes effective for plan years beginning on or after January 1, 2006 and is currently scheduled to expire at the end of 2010. The Internal Revenue Service ("IRS") has published proposed regulations that provide guidance on Roth contributions to 401(k) plans. The proposed regulations do not address Roth contributions to 403(b) plans; therefore, this discussion will focus primarily on Roth contributions to 401(k) plans.
As the name suggests, the new Roth 401(k) program combines features of both Roth IRAs and 401(k) plans. Like the Roth IRA, the Roth 401(k) program permits participants to contribute after-tax dollars to a separate account that will generally not be subject to taxation in the future. However, unlike the Roth IRA, Roth 401(k) contributions are available to all participants regardless of their income level.
The Roth contribution program is optional for qualified 401(k) plans. Therefore, Roth 401(k) contributions will be available only to those participants in 401(k) plans whose sponsors adopt the Roth 401(k) program. The decision to adopt a Roth 401(k) program for a qualified 401(k) plan is a discretionary, "settlor function" of the plan sponsor and is not subject to ERISA's fiduciary considerations. However, if a plan sponsor decides to adopt a Roth 401(k) program, plan fiduciaries have a duty to comply with several mandatory administrative requirements in establishing and operating the program.
Key Roth 401(k) Features
The following is a summary of the key Roth 401(k) features:
- After-Tax Contributions, Tax Free Distributions: Roth 401(k) contributions are elective, after-tax contributions. The contributions are includable in the gross income of the participant at the time of deferral; however, a qualified distribution of a Roth contribution and any earnings thereon are excludable from gross income. (Qualified Roth 401(k) distributions are defined in the "Outstanding Issues" section below.)
- Irrevocably Designated Contributions: In order to make Roth 401(k) contributions, a participant must irrevocably designate contributions as Roth 401(k) contributions at or before the time of the deferral. The participant may not reclassify the Roth 401(k) contributions at a later time.
- Contribution Limit: Participants may designate any amount of the available deferrals for a plan year as Roth 401(k) contributions, subject to the applicable Code Section 402(g) limit in effect for that plan year. The Code Section 402(g) limit applies to all elective deferrals for a plan year, including Roth 401(k) contributions.
- No Income or Age Limit: All participants are eligible to make Roth 401(k) contributions regardless of their income level and age.
Administrative Requirements of Roth 401(k) Accounts
There are a number of administrative requirements for Roth 401(k) Accounts:
- Contribution Election: As noted above, participants must irrevocably designate deferrals as Roth 401(k) contributions at or before the time of the contribution. Therefore, plan administrators must complete the election process -- including drafting, distributing, collecting, and processing Roth 401(k) election forms -- before participants are eligible to make Roth 401(k) contributions.
- Separate Accounting: Roth 401(k) contributions must be contributed to, and maintained in, a separate account. The plan must maintain a record of each participant's investment of his designated Roth 401(k) account and must separately allocate all gains, loses, and other credits and charges in a manner consistent with other accounts. (Forfeitures may not be allocated to a Roth 401(k) account.) These separate accounting requirements apply to Roth 401(k) contributions from the time a contribution is made to the plan until all Roth 401(k) contributions are distributed.
- Elective Deferral Requirements: All Roth 401(k) contributions are nonforfeitable and subject to the same distribution restrictions generally applicable to elective deferrals, including the minimum required distribution rules.
- Nondiscrimination Testing: Roth 401(k) contributions are taken into account under the ADP test for 401(k) plans in the same manner as pre-tax elective deferrals. A plan may permit participants to designate whether excess contributions are attributable to pre-tax deferrals or Roth 401(k) contributions. However, any income allocable to a corrective distribution of excess contributions designated as Roth 401(k) contributions is subject to taxation.
- Matching Contributions: Employer matching contributions made with respect to a participant's Roth 401(k) contributions must be maintained in a separate account from the Roth 401(k) contributions. Furthermore, the matching contributions will be treated in the same manner as pre-tax contributions and will be subject to taxation when they are distributed to the participant.
- Rollovers: Roth 401(k) contributions may only be rolled over to one of the following: (i) another qualified 401(k) plan maintaining a designated Roth 401(k) contribution account; or (ii) a Roth IRA.
- Plan Amendment: Qualified 401(k) plans that decide to adopt and implement the Roth 401(k) program must amend their plan documents to address the above described features and requirements. Specifically, the Roth 401(k) proposed regulations require that plans be amended to explain the following: (i) the extent to which participants may classify Roth 401(k) contributions as excess contributions for the purposes of nondiscrimination testing; and (ii) that Roth 401(k) contributions may only be rolled over to another qualified 401(k) plan maintaining a designated Roth 401(k) contribution account or a Roth IRA. The IRS has not offered model amendments for this purpose.
The proposed regulations addressing the Roth 401(k) program left many important questions unanswered. These questions concern the following issues:
- Catch-Up Contributions. The proposed regulations do not address whether catch-up contributions may be made as Roth 401(k) contributions.
- Plan Amendments. There are currently no model amendments for 401(k) or 403(b) plans to adopt Roth contributions.
- Participant Communications. The IRS has not offered guidance on communication to participants regarding Roth 401(k) contributions. For example, there are currently no model notices regarding Roth 401(k) elections, distributions, or tax implications.
- Roth 401(k) Elections. There is currently no guidance on the Roth 401(k) election process, including guidance on when and how participants may elect or change a Roth 401(k) election or vary contributions between Roth 401(k) accounts and other deferral accounts.
- Existing After-Tax Deferrals. The existing Roth contribution program guidance does not address how the adoption of Roth 401(k) contributions affects 401(k) plans that already offer after-tax deferrals. For example, it is unclear whether Roth 401(k) contributions are intended to replace, or substitute for, after-tax deferrals currently offered by qualified 401(k) plans.
- Automatic Rollover Rules. There is a paucity of guidance on how the automatic rollover rules of Code Section 401(a)(31) affect Roth 401(k) distributions. The automatic rollover rules require plans to make automatic rollovers to an IRA; however, the Roth 401(k) rules require plans, in relevant part, to rollover any amounts attributable to Roth contributions to a Roth IRA. Therefore, it is unclear whether separate IRA accounts are required for deminimis distributions that include Roth 401(k) contributions.
- Automatic Enrollment. It is currently unclear whether it is appropriate to elect Roth 401(k) contributions for participants in plans that have an automatic enrollment feature.
- 403(b) Plan. Despite the fact that Code Section 402A states that 403(b) programs are eligible to adopt Roth contributions, the proposed regulations on the Roth contribution program do not address 403(b) plans.
- Reporting Requirements. There is no guidance on how Roth 401(k) contributions and distributions are to be reported on forms such as the 1099-R and W-2.
- Recordkeeping Requirements. The separate accounting required for Roth 401(k) contribution accounts gives rise to new recordkeeping requirements for plan administrators. However, the IRS has not offered guidance on recordkeeping for Roth 401(k) accounts, including how plan administrators should coordinate Roth 401(k) recordkeeping with the previous recordkeeping for pre-tax and after-tax contributions and earnings.
- Qualified Roth 401(k) Distributions. Available guidance makes clear that only "qualified" distributions of Roth 401(k) contributions will be exempt from taxation. Code Section 402A defines a qualified Roth 401(k) distribution as a distribution made: (i) at least 5 years after the date the participant contributed his first Roth 401(k) contribution; and (ii) after the participant reaches age 59½, dies or becomes disabled. A strict reading of these rules, without further guidance from the IRS, may result in numerous tax penalties for plan participants. For example, the rules suggest that a participant who retires less than five years after he first makes a Roth 401(k) contribution will nonetheless be taxed on any distribution he receives from his Roth 401(k) account if he does not wait until the five year period expires before taking a distribution. The rules also suggest that hardship distributions from a Roth 401(k) account taken before a participant reaches age 59½ will also be subject to taxation.
Advantages and Disadvantages of Implementing the Roth 401(k) Program
Plan administrators are advised to carefully weigh the advantages and disadvantages of implementing the Roth 401(k) program. However, there are clear advantages to implementing Roth 401(k) contributions:
- Roth 401(k) contributions will be a valuable retirement savings vehicle for participants who expect to retire in a higher tax bracket, and for highly compensated participants who are not eligible to make Roth IRA contributions.
- Plans will be able to test Roth 401(k) contributions as elective deferrals under the ADP test.
- Roth 401(k) contributions will carry lower administrative fees for participants as compared to the fees attendant to Roth IRAs.
There are also a number of disadvantages of the Roth contribution program, including the following:
- Numerous unresolved questions regarding the implementation and administration of the Roth 401(k) program. The paucity of guidance on key issues will have an immediate impact on plans implementing the program in 2006, such as how to administer Roth 401(k) elections.
- Participants are likely to request taxation and other financial information to assist in both making their deferral election decisions and taking withdrawals, distributions, and rollovers. This increased demand for information will pose numerous issues for plan fiduciaries, such as how to provide the relevant Roth 401(k) information without providing tax advice and how to provide accurate information in the absence of IRS guidance on key issues.
- Roth 401(k) accounts will increase administrative burdens and these increased administrative burdens will far outlast the limited 4 year window in which participants may make Roth 401(k) contributions.
As with most optional retirement plan features, the Roth 401(k) program is likely to be an increased benefit to plan participants and an increased administrative burden to plan administrators. As the January 1, 2006 effective date for the Roth contribution program nears, plan administrators are advised to consider whether the additional benefits will outweigh the additional costs over time.