A qualified Roth 401(k) contribution program is an arrangement authorized by IRC Section 402A that allows a 401(k) participant to elect to have all, or a portion, of his annual elective plan deferrals treated as Roth contributions.
Under the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), Roth 401(k) arrangements were available for 2006-2010 only – a very short lifespan.
However, the Pension Protection Act of 2006 gives these arrangements new life because it makes IRC Section 402A permanent after 2010, thus nullifying the sunset provision of EGTRRA.
There are several important advantages of Roth 401(k)s for wealthier clients. First, all participants are permitted to make a Roth 401(k) contribution. In contrast, an individual who files jointly and has modified adjusted gross income in excess of the $166,000 phaseout limit for 2007 cannot contribute to a Roth IRA.
Another advantage is that the limit on Roth 401(k) contributions ($15,500) by far exceeds the limit on Roth IRA contributions (up to $4,000 for 2007). Furthermore, the Roth 401(k) contribution limit for individuals age 50 or older is $20,500 for 2007.
Employer matching contributions may be made; however, they must be allocated to the participant’s 401(k) pretax account only and not to his or her Roth 401(k) account. A participant may roll over his or her distribution from a Roth 401(k) contribution account to another Roth 401(k) contribution account or to a Roth IRA.
The following “qualified distributions” to a participant (or his beneficiary) from a Roth 401(k) contribution account that has been open for at least five calendar years are tax-free (i.e., free from federal income taxes and the 10 percent premature distribution penalty imposed by the IRS): after age 59; on account of death or disability; or for first-time home buyer expenses up to $10,000.
There are, however, several disadvantages to Roth 401(k)s that should not be overlooked. First, a participant’s employer must treat Roth 401(k) contributions as taxable income to the participant at the time the employee would have received the contribution amounts in cash if the employee had not made the cash or deferred election (e.g., by treating the contributions as wages subject to applicable withholding requirements).
A participant also must irrevocably designate a contribution as a Roth 401(k) contribution at the time the qualified cash or deferred election is made. Hence, a participant cannot retroactively designate before-tax elective deferrals as Roth 401(k) contributions.
Roth 401(k) contributions are subject to distribution restrictions and can be made only on account of death, disability, termination of employment, attainment of age 59, or hardship. Hence, Roth 401(k) participants have very limited access to elective deferrals made to their accounts. In contrast, Roth IRA participants can access their contributions at will.
Roth 401(k) contributions are also subject to the same age 70 minimum required distribution rules that apply to pretax 401(k) elective contributions. In contrast, Roth IRA owners (but not their beneficiaries) are exempt from these rules. To overcome this disadvantage, Roth 401(k) distributions may be rolled over to a Roth IRA to avoid the age 70 required distribution rules.
Now that Roth 401(k) arrangements are a permanent part of the retirement landscape, it makes sense for advisors to fully explore this planning technique as an option for their clients.