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Roth 401(k): The new retirement alternative

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We waited longer than expected for the IRS to issue final regulations regarding the Roth 401(k) feature. Beginning Jan. 1, 2006, employers that sponsor 401(k) retirement plans may offer a new plan design feature that will be known as after-tax Roth deferrals.


Currently, salary deferral contributions to 401(k) plans are made on a pre-tax basis and are taxed when distributed. The new Roth deferral is made on an after-tax basis, i.e. taxes are withheld at the time the deferrals are contributed to the plan.

Then, if certain conditions are met, distribution of earnings will be tax-free. A plan that permits participants to make Roth deferrals as well as the traditional pre-tax deferrals will allow individual participants, based on their specific circumstances, to make current taxation choices. These choices may have substantially different tax outcomes at retirement when the accumulation phase is over and they begin to take distributions from their retirement accounts.

Although there has been a tremendous amount of discussion about the new Roth 401(k), debate revolves around who will benefit from the after-tax deferral feature.

Much has been written recently by tax analysts regarding the Roth 401(k) feature. It has been described as an important tax alternative that may be valuable to employees who are currently saving for retirement through existing 401(k) plans. There are several categories of participants who may benefit from the Roth feature.

Currently, highly paid employees are unable to contribute to Roth IRAs due to income restrictions on these retirement vehicles. For 2005, single filers that earn more than $95,000 and joint filer's earnings more than $150,000 will be unable or will be restricted in their ability to make contributions to a Roth IRA.

However, these income limits do not apply to Roth 401(k) savings. Thus, highly paid employees will be able to enjoy Roth savings for the first time and could conceivably defer as much as $20,000 into the Roth deferral account in 2006 (assuming age 50 or older).

Younger employees who are currently in a lower tax bracket may find that electing Roth deferrals may result in minimal additional tax burden. The longer the time until retirement, the more the impact of compound interest, and the ultimate tax free value of Roth earnings could exceed the ultimate after-tax value of pre-tax earnings growth.

Employees interested in estate planning opportunities may also benefit from the Roth 401(k). Many financial professionals are promoting Roth savings for estate planning purposes. Estate planning and taxation on estates is complicated and varies based on state laws. An individual contemplating Roth savings should seek expert tax advice. However, many experts believe the wealthy individuals will not use all of their retirement savings and may want to leave their heirs with significant assets. They may be able to increase their transfer of wealth through Roth savings.

When deciding whether or not to contribute to a pre-tax or after-tax 401(k) plan, a participant should consider several factors:

* Will a pre-tax deferral lower the participants' current tax bracket? * If electing to make a Roth deferral, participants must be able to afford the lower take home as a result of increased taxed withholding. * If the participant reduces the Roth deferral so that the participant's take home pay is the same as with a pre-tax deferral, will that reduction result in a lower employer matching contribution? * By the time the participant takes a distribution from the plan or retires, does the participant anticipate that their personal tax rate and tax bracket will increase or decrease because of a change in the income and/or a change in their tax rates by the IRS? * If the participant chooses a pre-tax deferral, will the participant invest this take home pay increase in a profitable after-tax investment until retirement, or will the participant spend the difference in take-home pay? * Will the participant lose other tax deductions because the Roth deferral raises the adjusted gross income? * Is it a concern to the participant to be able to avoid require minimum distributions at age 70 1/2 and thus take advantage of generation skipping estate planning opportunities with a Roth IRA?

There will also be some impact to the employer's payroll system when adding the Roth feature. Payroll vendors are currently developing capabilities to support Roth deferrals. When a pre-tax deferral is made, no federal or state income tax withholding is calculated on that contribution. But, when a Roth deferral is made, federal withholding tax is taken and state withholding is generally required as well.

The Roth feature will also impact W-2 reporting. If the plan sponsor, plan administrator and/or trustee are interested in offering the Roth feature, early discussions with the payroll vendor and internal payroll department and adequate testing of updated payroll systems should be performed well in advance of the introduction of the Roth feature to plan participants.

Since the inception of the proposed regulations surrounding the Roth 401(k), distributions have been an area with many questions. Pre-tax deferral accounts accumulated earnings are subject to federal and state income tax when distributed.

A "qualified distribution" from a Roth deferral account is not subject to federal and state tax-both contributions and associated earnings are distributed tax free. If a distribution from a Roth deferral account is made prior to satisfying the requirements of a "qualifying distribution" then the earnings are taxed, and the 10 percent premature distribution penalty may apply to the earnings portion of the distribution.

When exploring the Roth feature, one should pay careful attention to what constitutes a qualified or non-qualified distribution.

The Roth deferral is part of the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA). EGTRRA introduced many plan provisions that could expire Dec. 31, 2010 -- including the Roth feature.

Experts anticipate that the EGTRRA features will become permanent, however, plan sponsors should weigh this issue as they consider adding the Roth deferrals to their retirement plan. For more information about Roth 401(k) plans, visit the IRS Web site at www.IRS.gov.

Peartree is a principal with Barney & Barney and is director of the company's Retirement Services Division. For more information call (858) 550-4978 or e-mail billp@barneyandbarney.com.>

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