This is the first year that an individual participating in a 401(k) or 403(b) plan can also make Roth contributions to the same plan.
Although the Roth 401(k) and Roth 403(b) programs are still in their infancy, the Internal Revenue Service already is indicating it is open to refining the rules. Life insurance agents and others who work with retirement plans should keep an eye out for changes.
Congress gave 401(k) and 403(b) plans the ability to offer a Roth feature when it passed the Economic Growth and Tax Relief Reconciliation Act of 2001, which created Section 402A of the Internal Revenue Code.
According to the EGTRRA conference report, Congress wanted to give retirement plan participants the kind of choice individuals already had to decide between deductible and Roth individual retirement account contributions.
Unlike most EGTRRA provisions, which took effect in 2002, the Roth feature took effect in Jan. 1, 2006. So, until this year, an individual who was looking to balance pre-tax and Roth retirement savings could do so only in separate retirement vehicles – through a Roth IRA and either an employer-sponsored plan or a traditional IRA.
Now, the Roth 401(k) and 403(b) plan feature lets a participant contribute a total of $15,000 in 2006 (before any available catch-up contributions and subject to applicable nondiscrimination testing) to be allocated among pre-tax and Roth accounts under the plan. An employee can maximize his tax-free withdrawals by designating all $15,000 as his annual Roth contribution.
If an individual chooses instead to make contributions to a Roth IRA, the most he could contribute to the Roth IRA in 2006 would be $4,000 (before a catch-up provision for taxpayers ages 50 and older) – presuming that he was eligible to contribute to a Roth IRA at all.
Only individuals with both taxable compensation and modified adjusted gross income under $160,000 (if a joint federal income tax filer) or $110,000 (if a single filer, head of household or married filing separately) can contribute to Roth IRAs.
Under these circumstances, a retirement plan’s Roth feature can provide more savings opportunities for more individuals.
Roth feature not the same as IRA
A retirement plan’s Roth feature and a Roth IRA let an individual access earnings tax-free if his withdrawal is a “qualified distribution.” However, a qualified distribution under a retirement plan is not as broad as from a Roth IRA.
A plan participant has a “qualified distribution” if he made his first Roth contribution at least 5 tax years ago and is now withdrawing the money due to reaching age 59 1/2 , becoming disabled, or (in the case of his beneficiaries) dying.
If a participant does not have a “qualified distribution,” he may nevertheless access Roth amounts under the plan rules – for example, severance of employment or hardship – but will need to pay income taxes (and potentially an IRS 10% premature distribution penalty tax) on the attributable earnings.
When an individual who withdraws money from a Roth IRA due to reaching age 59 1/2 , becoming disabled, or (in the case of his beneficiaries) dying also has a qualified distribution, a Roth IRA has one additional event that will give an individual tax-free access: withdrawal up to a $10,000 lifetime limit for first-time home purchase.
Coming attractions from the IRS:
On July 26, the IRS held hearings to allow the public to testify on proposed regulations addressing Roth distribution rules from 401(k) and 403(b) plans.
Among the common themes in the testimony were calls for:
–Simplified administration of hardship withdrawals.
–Loan administration guidance for plans that have Roth features, including advice about whether separate loan agreements, checks and amortization schedules are needed.
–Clarification about how the 5-year period would be determined if a “citizen soldier” employee were to make retroactive Roth contributions to the plan, pursuant to the Uniformed Services Employment and Reemployment Rights Act of 1994.
–An update of the IRS’ model tax notice, to reflect Roth 401(k) and Roth 403(b) rollover rules.
Meanwhile, the IRS has provided a sample model amendment for 401(k) plans that adopt a Roth feature.
Because the model is merely a sample, sponsors need not adopt the amendment verbatim. In fact, the IRS cautions that the sample amendment may need modification to fit with a particular plan’s terms.
The 401(k) sponsors who offer a Roth 401(k) feature must amend their plans by the end of the plan year in which the Roth feature was first effective.