• Roth Contributions -- A Powerful Savings Tool
  • March 9, 2005 | Author: Claire E. McCusker
  • Law Firm: Pepper Hamilton LLP - Philadelphia Office
  • Roth contributions are a powerful new savings tool that plan sponsors should consider offering to their employees.

    The Internal Revenue Service issued proposed regulations on March 2, 2005, implementing Section 402A of the Internal Revenue Code, which contains the rules regarding Roth contributions. Effective January 1, 2006, 401(k) plans and 403(b) plans may offer participants the opportunity to designate their elective deferrals as "Roth contributions." Roth contributions are after-tax contributions that, in general, are distributed tax-free. Unlike Roth IRAs, where income limitations apply, participants at all income levels are eligible to make designated Roth contributions.

    Roth contributions are treated for all purposes of the tax code (other than their ultimate taxability) like pre-tax deferrals: they are subject to discrimination testing as pre-tax contributions, they can only be withdrawn in-service in connection with a hardship, and otherwise they are not distributable until termination of service, death, disability or attainment of age 59½. Note, however, that Roth contributions are not eligible for favorable tax treatment if they are distributed within five years of the date that a participant first makes Roth contributions.

    Roth contributions are made in lieu of, not in addition to, pre-tax 401(k) and 403(b) deferrals. In 2006, a participant's combined pre-tax deferrals and Roth contributions cannot exceed $15,000 (plus an additional $5,000 for participants age 50 and over). Roth contributions can be matched in the same manner as pre-tax contributions. Because section 402A provides that Roth contributions are treated as elective deferrals, we believe that safe harbor 401(k) plans that match pre-tax deferrals and Roth contributions can continue to avail themselves of safe harbor status and continue to avoid discrimination testing. However, the IRS has not yet stated this affirmatively.

    Plan sponsors should seriously consider the addition of a Roth contribution feature to their existing defined contribution plans, because they offer a very powerful savings tool for employees. For many employees, due to the power of compounding, it will be more advantageous to make after-tax contributions early or in the middle of their careers that can be withdrawn tax-free later. In addition, employees who meet the income limits applicable to Roth IRAs can still make Roth IRA contributions.

    Section 402A was enacted by the Economic Growth and Tax Relief Reconciliation Act (EGTRRA). EGTRRA's provisions expire effective for plan years beginning after December 21, 2010, absent legislative action. Even given the possibility that this feature may only be available for five years, it is still worth considering seriously.

    Plan sponsors will need to take several steps to proceed with the addition of a Roth contribution feature to their plans:

    • work with recordkeepers to establish mechanisms for separately accounting for Roth contributions
    • revise election procedures, as well as administrative services agreements
    • amend plans to reflect a number of provisions related to Roth contributions, including, for example, the order in which these contributions will be withdrawn in the event of hardship or other distribution
    • revise summary plan descriptions and other employee communications to reflect this new feature

    Because of the complexity of some of the administrative issues involved with implementing this feature, plan sponsors wishing to implement Roth contributions at the earliest possible date (January 1, 2006) should begin to act now and aim to finalize documents and administrative procedures promptly upon the issuance of final regulations later this year.