New for 2006: Roth 401(k)s

The Economic Growth and Tax Relief Reconciliation Act of 2001, Section 617, adding Sec. 402A, established the ability of Sec. 401(k) plan participants to designate part or all of their plan contributions as Roth contributions. The provision is scheduled to become effective on Jan. 1, 2006, for plans that have been amended to allow such contributions. While contributions are not excluded from income, distributions will not be taxed, provided certain criteria are met. This item discusses some of the contribution and distribution rules.

Qualifying Contributions

To qualify as designated Roth 401(k) contributions, three requirements must be met. First, the employee must irrevocably designate amounts as Roth contributions at the time of the cash or deferred election. The taxpayer cannot decide later that tax savings are needed for the current year and redesignate the contributions to a regular Sec. 401(k) plan. Second, contributions must be included in the employees income at the time the employee would have received the funds had he or she not elected to contribute to the qualified Roth contribution program. Finally, amounts must be maintained by the plan in a separate, designated Roth account.

Nontaxable Distributions

For distributions from a Roth 401(k) to be nontaxable, they must occur after the five-year period beginning with the tax year of the employees first contribution. Distributions must be made (1) on or after the taxpayer attains age 59, (2) after the taxpayers death or (3) on account of the taxpayers disability.

Advantages

The designated Roth 401(k) provides an attractive new retirement savings opportunity for taxpayers. They may now invest larger amounts in a wide variety of accounts, including mutual funds, bonds, the stock market, company stock, etc. Roth IRA contributions are currently limited to $4,000 in 2006 (with a $1,000 catch-up provision for those age 50 and over). The new Roth 401(k) allows a maximum contribution of $15,000 for 2006, with a $5,000 catch-up for those over age 50; see Sec. 402(g)(1).

Distributions are required once an employee reaches age 70. However, the assets in a Roth 401(k) plan can be rolled over into a Roth IRA (for which distributions are not mandatory). The taxpayer can still make a Roth IRA contribution. Unlike a Roth IRA, a Roth 401(k) has no adjusted-gross-income limits to restrict eligibility.

Conclusion

The Roth 401(k) provisions will allow a Sec. 401(k) plan to function much like a Roth IRA. Unfortunately, there is currently no way to transfer funds from a traditional Sec. 401(k) plan to a Roth 401(k); however, this problem will most likely be addressed in future guidance. For more details and a discussion of the Roth 401(k) proposed regulations, see Walker and Haberman, Employee Benefits & Pensions: Current Developments,  this issue.

From David M. Oleasz, CPA, and Clifford A. Rankin, CPA, CVA, Harper & Whitfield, P.C., Farmington, CT