The Roth 401(k) and Roth 403(b) — A Great Planning Opportunity

By Jeremy Chambers & Judy Young

Employee Benefits

Universal Advisor, 2005 Issue No. 1

Beginning in 2006, employers that sponsor 401(k) or 403(b) retirement plans will be eligible to include Roth contributions — a potentially wonderful opportunity for employers looking to help staff boost retirement savings. Although this article references only the 401(k) Roth feature, rest assured that the information also applies to the 403(b) plans available to nonprofit entities.

What’s a Roth 401(k) Program?

A Roth 401(k) program is a new feature that may be included in 401(k) retirement plans beginning in 2006. Under this program, an employee can elect to have all or a part of his/her 401(k) salary deferrals contributed on an after-tax basis. The total pre-tax and after-tax deferrals are limited to the annual maximum deferrals in effect that year. For 2006, the limits are:

Regular deferrals $15,000

Catch-up contributions (for those age 50 or older) $ 5,000

Total $20,000

Why Should an Employer Consider Adding a Roth to Its 401(k) Retirement Plan?

There are a variety of components that make the Roth 401(k) desirable. To begin, distributions are generally tax free; thus, earnings on contributions may never be taxed. In contrast, taxes on the earnings in regular 401(k) accounts are only deferred until the participant receives distributions, and even investment earnings that may otherwise be treated as capital gains in the account come out as ordinary income.

Second, if an employer expects its participants’ income tax rates to increase or thinks their retirement tax brackets will be equal to or higher than they are now, a Roth program should be a strong consideration for its retirement plan. Since the contribution is taxed when it’s deferred, the earnings grow tax free and, with the time value of money, this can be a great advantage.

In addition, Roth deferrals are not subject to the minimum distribution rules (at age 70 ½) for the participant. However, upon the death of the participant, the Roth 401(k) accumulations are subject to the minimum distribution rules for the beneficiaries.

Finally, a Roth account can be an important estate planning tool, as the qualified distributions to beneficiaries are also income tax free. This may be a substantial income tax savings for beneficiaries, especially if the participants have large pre-tax retirement accumulations.

Any Cautions?

Roth deferrals are subject to discrimination testing, just like pre-tax deferrals. Therefore, the right plan design is critical (that is, employers should consider safe harbor plans, new comparability profit-sharing allocations, etc.), and analyses of participation, employee income levels, and current plan design need to be performed.

In addition, separate accounting is required for the Roth deferrals and earnings, so the vendor an employer has or selects must be able to administer this new feature. The vendor must also be able to provide the right investment options. Investment education remains critical — participants continue to want gains on investments. In addition, it’s critical that participants are informed of the different tax consequences between the Roth 401(k) and the traditional 401(k) plans.

Roth programs aren’t for everyone. Lower-paid employees may benefit more by not using the Roth program. Also, if an employer expects its participants to be in a much lower tax bracket in retirement, the program may be less favorable for those individuals.

Calendar Year 2005

Even though guidance is expected to be released this summer, employers should begin to look at the opportunities a Roth program may provide their employees. It’s important for employers that wish to consider the advantages of a Roth 401(k) program to review the current 401(k) plan provisions, participation, and demographics, as well as the administration capabilities, investment choices, and level of investment education available from providers.

Reviewing 401(k) retirement plans now provides employers adequate time to determine whether this option will be beneficial for its employees. If an employer decides that the Roth 401(k) feature will be valuable, it’s important to begin updating documents and implementing appropriate communication strategies so that it’s ready to take advantage of this unique benefit structure as soon as the 2006 plan year begins.

For more information, or assistance in determining if a Roth 401(k) or 403 (b) retirement plan is right for your employees, please contact Jeremy Chambers at 248.375.7241 or Judy Young at 847.628.8846.