ROTH 401(k) PLANS

General.  For Plan Years beginning in 2006, 401(k) Plans may permit Roth 401(k) contributions. Whereas traditional 401(k) elective deferrals are made on a pre-tax basis, Roth 401(k) deferrals, like Roth IRA contributions, are made on an after tax basis and generate earnings excludable from gross income with respect to a qualified distribution. The Section 402(g) limit applies to Roth 401(k) elective deferrals, not the IRA contribution limit. Accordingly, a participant may make a Roth 401(k) deferral of up to $15,000 (with an additional $5,000 catch-up contribution for participants who have attained age 50) as compared to the $4,000 Roth IRA limitation. Whereas an individual is subject to income limitations in order to be eligible to contribute to a Roth IRA, a 401(k) participant may make designated Roth deferrals without regard to the participant's income.

Specifics of a 401(k) Qualified Roth Contribution Program.

• The employee must designate the Roth deferral at the time of election and the designation is irrevocable.
• The Roth deferrals are includable in taxable income as wages and are subject to normal withholding requirements.
• The Plan must separately account for the Roth contributions and earnings.
• Roth deferrals are treated as elective deferrals for all purposes in the 401(k) Plan.  For example, Roth deferrals are counted as elective deferrals in the ADP test.
• Roth deferrals are always 100% vested.
• Any employer matching contributions attributable to Roth deferrals are always pre-tax. 
• Roth 401(k) accounts are subject to the standard distribution restrictions on elective deferrals (death, disability, age 59 ½, severance of employment, hardship [deferrals only, not earnings])
• There is no tax on "qualified distributions."  Qualified distributions must satisfy two conditions:  (1) the occurrence of a qualifying event (age 59 ½; death; or disability) and (2) completion of a 5-year non-exclusion period.  The 5-year non-exclusion period commences as of January 1 of the year in which the participant makes his/her first Roth deferral.
• Roth 401(k) deferrals are subject to the required minimum distribution rules.  Note, however, that Roth IRAs are subject to the minimum death distribution rules but not the lifetime required minimum distribution rules.  Accordingly, a participant in a Roth 401(k) Plan may avoid the lifetime minimum distribution rules by rolling over his/her designated Roth 401(k) account to a Roth IRA.

Traditional Pre-tax 401(k) Elective Deferrals vs. Roth 401(k) Deferrals.  In choosing between Roth deferrals vs. pre-tax deferrals, each participant must perform an individual comparison.  The following considerations generally favor Roth contributions: 

The participant has the financial wherewithal to defer the same amount under the Roth on an after-tax basis as the participant could defer on a pre-tax basis;
 

The participant's post-retirement tax rate will either remain constant or increase; and
 

The participant does not need to receive required minimum distributions so that the Roth 401(k) account can be rolled to a Roth IRA to perpetuate the tax free accumulation of earnings until the participant's death.

The following considerations generally favor traditional pre-tax 401(k) deferrals:

The participant would defer less in a Roth because of the after tax nature of the contribution (this is especially important if there is an employer match); and

The participant's post-retirement tax rate is expected to decrease.

Illustrations. 

#1 Participant P is age 50 and defers the maximum $15,000 plus a $5,000 catch-up deferral every year through age 65.  Assume P is in a 35% tax bracket and P's investments earn on average 7%.  P rolls the balance to a Roth IRA to avoid lifetime minimum distributions and dies at age 85.  P needs $30,770 to pay the 35% taxes and defer $20,000 on an after tax basis.  For comparison purposes, assume that if P deferred $20,000 in a traditional pre-tax 401(k) that P would have paid tax of approximately $3,770 on the $10,770 and invested the remaining $7,000 also at 7% pre-tax (or 4.55% after tax) earnings rate.

Roth 401(k)	Traditional Pre-Tax 401(k)
Balance at age 85 = $2,230,870 If child age 55 is beneficiary, payments over 30 year life of child would be $179,707 per year (tax free). If grandchild, age 30 is beneficiary, payments over 55 year life of grandchild would be $160,000 per year (tax free). $310,000 advantage at the participant's death.	Pre-tax balance after minimum distributions commencing at age 70 ½ = $1,188,600 or $773,600 after tax. For comparison, assume that all minimum distribution amounts were reinvested after taxes yielding $757,500; and the $7000 annual investment was never spent to yield $389,500 at age 85.  The total, after tax, at age 85 is $1,920,600.

#2 Participant is age 35, defers $4000 each year through age 65, earns 7% and pays 25% taxes both pre and post retirement.  [Note that as a distinction from illustration #1, this illustration and illustrations 3, 4 and 5 do not anticipate that the tax differential between the Roth and traditional 401(k) would be invested and retained through age 65.]

Roth 401(k)	Traditional Pre-Tax 401(k)
$377,843 income tax free	$283,383 after income tax

 #3 Participant in illustration #2 has income tax rate decrease from 25% to 15% at retirement.

Roth 401(k)	Traditional Pre-Tax 401(k)
$377,843 income tax free	$321,116 after income tax

 #4 Rather than pay the $1000 income tax in order to make a $4000 after tax contribution, Participant in illustration #2 makes a $5000 traditional pre-tax 401(k) contribution.

Roth 401(k)	Traditional Pre-Tax 401(k)
$377,843 income tax free	Pre-tax $472,304 After 15% tax, $401,458 after income tax At 25% tax rate, $354,228 after income tax

 #5 Your employee retirement education program has been successful and your employees have recognized the power of time relative to their retirement account.  Participant P starts making $4000 deferrals at age 25 through retirement at age 65 and earns 7%.

Roth 401(k)	Traditional Pre-Tax 401(k)
$798,540 income tax free	$598,905 after income taxes (25% rate)

Implementation of the Roth 401(k). The Roth 401(k) feature is a choice. It is not required. In order to implement the choice, Plans must be amended to allow the Roth 401(k) feature. If it is desired, Plan's must be amended by the last day of the Plan Year in which the employer adopts the Roth feature. At the present time, we are awaiting additional IRS regulations regarding the Roth 401(k) and it is anticipated that these regulations will include guidance with respect to the required form of amendment. It is anticipated that this guidance will be issued later this year or early 2006. In the meantime, please consider whether this is a feature that you would like to have as part of your Plan and if so, please contact me with any questions or notify me so that a Roth amendment is made at the earliest possible time.  

For additional information, please contact:

David M. Mosier, Esq.
Knox, McLaughlin, Gornall & Sennett, P.C.
120 West Tenth Street
Erie, Pennsylvania 16501-1461
Telephone (814) 459-2800; Fax (814) 453-4530
E-mail: dmosier@kmgslaw.com

This Guide and any information in it is not to be reproduced in whole or in part, in any medium, for use by others without the prior, express written consent of Knox McLaughlin Gornall & Sennett, P.C.