Section Review

The lowdown on the Roth 401(k)

Roberto H. Solano Jr. is a financial advisor with Smith Barney located in Boston. For more information, call (617) 557-6964.

Citigroup Inc., its affiliates, and its employees are not in the business of providing tax or legal advice. These materials and any tax-related statements are not intended or written to be used, and cannot be used or relied upon, by any such taxpayer for the purpose of avoiding tax penalties. Tax-related statements, if any, may have been written in connection with the “promotion or marketing” of the transaction(s) or matters(s) addressed by these materials, to the extent allowed by applicable law. Any such taxpayer should seek advice based on the taxpayer’s particular circumstances from an independent tax advisor.

Smith Barney is a division of Citigroup Global Markets Inc. Member SIPC.

On Dec. 30, 2005, the IRS issued final regulations for Roth 401(k) plans, effective January 3, 2006. Authorized under the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA”), this type of retirement account combines features currently available with Roth IRAs with those available with traditional 401(k) plans. Employers now have the option to offer these new Roth 401(k) accounts in addition to their traditional 401(k) plans. And, an employee with a Roth 401(k) can still have a Roth IRA as long as the income limitations required for a Roth IRA are met. Additional guidance on Roth 401(k) plans is expected in the future.

Plan requirements

A traditional 401(k) plan must be amended to allow explicitly for designated Roth 401(k) contributions. The plan participants have to make an election for the contribution to be treated as a contribution to the Roth 401(k). The Roth 401(k) contributions and earnings must be maintained in a separate account from traditional 401(k) contributions and earnings. Forfeitures cannot be allocated to a Roth 401(k) account.

Contributions

While contributions to a traditional 401(k) plan are made with pretax dollars, contributions to a Roth 401(k) plan are made with after-tax dollars, so there are no tax deductions when the contribution is made. Similar to a Roth IRA, the assets in the Roth 401(k) will grow tax-free. Withdrawals can be made after the account holder turns 59-1/2 and, as long as the money was held in the account for five years, the distributions including earnings will be tax- and penalty-free.

The maximum contribution to a Roth 401(k) plan is the same as allowed in a traditional 401(k). For example, in 2006, the maximum contribution is $15,000. If an employee wants to contribute to both a Roth 401(k) plan and a traditional 401(k) plan, the maximum combined contribution to the two plans in 2006 is $15,000. Employees may not contribute $15,000 into each separate plan, as every dollar contributed to a Roth 401(k) will reduce the amount that can be contributed to a traditional 401(k) plan. There is no provision for company matches of Roth 401(k) contributions. Any company contributions will continue to go into the employee’s traditional 401(k) account and will be treated as pre-tax contributions.

Income limitations

There are no income limitations on the Roth 401(k), unlike Roth IRAs where single individuals with more than $110,000 in adjusted gross income (and married couples who have more than $160,000 in adjusted gross income) are ineligible for contributions.

Required minimum distributions

With a Roth IRA, an account holder is not subject to Required Minimum Distributions (RMD). However, with a Roth 401(k), there are RMD requirements from the account once the account holder turns 70-1/2. Under the regulations, the RMD requirement could be avoided by rolling the Roth 401(k) into a Roth IRA when a plan participant separates from service.

Conversions

The proposed regulations do not allow for traditional 401(k) plans to be converted to Roth 401(k) plans.

Catch-up contributions

Plan participants age 50 and over may make $20,000 in Roth contributions to their Roth 401(k) in 2006 ($15,000 regular contribution and a $5,000 catch-up contribution).

Open issues

The Roth 401(k) is scheduled to sunset along with the rest of the EGTRRA legislation at the end of 2010, meaning that unless Congress extends them, no additional money could be put into a Roth 401(k) beginning January 1, 2011. Money already contributed to a Roth 401(k) plan would remain in the plan.

The Roth 401(k) plan will offer employees a new alternative in saving for retirement. It will allow individuals, regardless of their income level, to take advantage of the tax-free benefits in their retirement savings account. However, the decision to make contributions to a Roth 401(k) rather than a traditional 401(k) plan should only be made after a thorough analysis of the tax consequences is completed.

©2014 Massachusetts Bar Association