August 9, 2005

There is Still Time

There is still time for an employer to modify its 401(k) or 403(b) plan to implement "Roth contributions" by participants in 2006, but a decision must be made soon.

Qualified 401(k) plans and 403(b) arrangements may permit plan participants to designate their contributions as either traditional salary deferrals or as designated Roth contributions for tax years beginning after this year. Unlike traditional salary deferrals, Roth contributions are made with after-tax dollars, and upon distribution the Roth contributions and earnings are not subject to federal income tax. The Economic Growth and Tax Relief Reconciliation Act of 2001 amended the Internal Revenue Code to allow plan sponsors to include a Roth contribution option in their plans. Roth 401(k) and 403(b) contributions have the same contribution limits as pre-tax salary deferrals, including age 50 catch-up contributions, and are subject to the same nondiscrimination testing. Unlike the Roth IRA, all plan participants may contribute to a Roth 401(k) or 403(b), regardless of their adjusted gross income.

Who May Benefit?

Employees who believe that their marginal tax bracket after retirement will be higher than their current tax bracket may want to consider making Roth contributions. Factors in making this decision include estimating what the tax rates will be at retirement and whether, if rates do not change, greater income after retirement than at the time of contribution will push them into a higher bracket. Required minimum distributions may be avoided if the Roth account is rolled over into a Roth IRA, allowing high net worth individuals to pass along their accounts at death to beneficiaries who can then withdraw tax paid benefits over their lifetimes.

For example, assuming a $15,000 contribution withdrawn after 10 years, a return of 6% inside and outside the plan, and a marginal tax bracket of 25% throughout the period:

Obviously, changes in tax rates and different investment results inside and outside the plan could make a large difference.

Other Considerations

The law that created Roth designations is scheduled to expire at the end of 2010, which would end this feature unless something changes. Also, there are still some unanswered administrative issues, and addition of the Roth feature may be confusing to participants. Despite possible drawbacks, some employers might decide that there is no real harm in offering the Roth option to plan participants. Others may decide that it is not worth the hassle.

What Needs to Be Done by Year-End?

An employer interested in implementing the Roth option will need to make sure that its payroll system will accommodate adding Roth contributions. It also must confirm that the plan’s recordkeeper or third party administrator can handle the addition of Roth accounts. Changes may need to be made to the plan documents so that they will include the necessary provisions to provide for Roth accounts and their proper administration. It is unclear at this time whether the amendments must be made by December 31 or may be made later. In addition, employers must adopt a plan for communicating the new Roth option to participants.

If you have any questions regarding this alert or other Employee Benefits Law related issues, please contact Marc Harris at 704.342.5304 or cmharris@poynerspruill.com or one of our other Employee Benefits attorneys.