In a previous article, Introducing The Roth 401(k), we provided a high-level overview of the Roth 401(k). When the article was written, the Roth 401(k) regulations were in a proposed format. On December 30, 2005, the Treasury Department and the IRS issued final regulations and they came into effect on January 3, 2006. In this article we examine some of the issues addressed in the final Roth 401(k) regulations and look at the factors that may affect your decision to participate.
Highlights of the Final Roth 401(k) Regulations
Application of RMD Rules Confirmed
Because regular Roth IRAs are not subject to required minimum distribution (RMD) rules, many people feel that the application of such rules to the Roth 401(k) in the proposed regulations was a mistake. However, the final regulations confirm that Roth 401(k) assets are not expressly excluded from the RMD rules. As such, owners of Roth 401(k) accounts must begin RMDs the year they reach age 70½.
As with traditional 401(k) plans, an employer may include an automatic deferral arrangement under a Roth 401(k). Under such arrangements, employees who do not affirmatively make a deferral election (including an election not to make deferral contributions) will be treated as having made a choice as determined under the plan's automatic deferral arrangement provision. The requirements for such automatic enrollments are explained in detail in Revenue Ruling 2000-8.
Only Roth 401(k) Contributions and Certain Rollovers Allowed
The only contributions that can be made to a Roth 401(k) account are Roth 401(k) deferral contributions and rollover contributions from other Roth 401(k) and Roth 403(b) accounts. Therefore, forfeiture contributions, matching contributions and other contributions that are not Roth 401(k) contributions cannot be made to Roth 401(k) accounts.
Roth 401(k) assets can be rolled over to other Roth 401(k)s, to Roth 403(b)s and to Roth IRAs. Similar to qualified plan rules, an employer need not allow a direct rollover for plan balances that are under $200. For this purpose, Roth 401(k) balances need not be aggregated with other plan balances.
A non-qualified distribution from a Roth IRA is subject to income tax only to the extent that the distribution includes earnings. With Roth IRAs, basis is recovered before any earnings are distributed as determined under the ordering rules. However, distributions from Roth 401(k) accounts will include a prorated amount of basis and earnings. As such, non-qualified distributions will be taxed, but only on the amounts that are attributed to earnings. The determination of whether a distribution from a Roth 401(k) is qualified, and the amount of basis included in such distributions, must be made by the plan administrator. This is unlike the Roth IRA, where the account owner is responsible for keeping track of the basis and determining whether distributions are qualified.
Generally, the IRS issues sample language that is used to make amendments to qualified plans in order to adopt new regulations. However, such language has not yet been issued for Roth 401(k)s. Until such language has been issued, employers may still operate Roth 401(k) accounts without these sample amendments, provided they follow the rules as stated in the final regulations.
Is the Roth 401(k) Right for You?
As is the case when choosing between a Traditional IRA and a Roth IRA (see Roth Or Traditional IRA...Which Is The Better Choice?), you need to consider several factors when deciding whether to make deferral contributions to either a traditional 401(k) or a Roth 401(k) account. The following are some to think about.
Reduction of Income Taxes Now vs Tax-Free Income Later
Making elective deferral contributions to a traditional 401(k) account will generally result in a reduction of income taxes assessed on your salary. However, these amounts – and any attributable earnings – are taxed when withdrawn. With the Roth 401(k), however, contributions are made on an after-tax basis, but qualified distributions are tax free.
The tax-free distributions are an attractive feature, but first you should make a careful assessment of what your income status will be when you begin making withdrawals from your Roth 401(k). If you project that your income tax rate during retirement will be similar to your current income tax rate, then it may not make much financial sense to pay the taxes now instead of later. Instead, taking the tax break now by deferring into your traditional 401(k) plan may be the better option. Work with your financial planner to look at all factors, including current tax deductions versus projected deductions, your current income versus your projected income and your current versus your projected tax rate during your retirement years. These and other factors will affect the amount of taxes you pay on your contribution dollars.
Reducing Your RMD Income
While both traditional and Roth 401(k)s are subject to the RMD rules, RMDs from Roth 401(k)s will be tax free if qualified. As such, RMDs from your Roth 401(k) account will not increase your taxable income. Therefore, if you are looking to reduce the taxable income that would be generated from your RMDs, you may want to consider diverting some or all of your deferrals to a Roth 401(k) account. (To learn more, see Strategic Ways To Distribute Your RMD.)
Consider a Split
There are a couple of reasons why you may choose to split your contributions between both a traditional 401(k) and a Roth 401(k). First, if you are unable to make any realistic projections about your financial status during retirement, dividing your contributions between both types of accounts may be a good way to hedge your bets. Second, your financial planner may just decide that it makes sense for you to split your deferrals between your traditional and Roth 401(k) accounts, as this would allow you to enjoy the benefits offered by both accounts.
Employers Must Offer a Traditional 401(k) To Offer a Roth 401(k)
In order to offer the Roth 401(k), your employer must include it as part of a traditional pre-tax 401(k) plan. In other words, a Roth 401(k) cannot be established as a stand-alone plan. You should be notified by your employer if the Roth 401(k) feature has been added to any plan in which you are eligible to participate. If it is not offered under your employer's plan, then you will not be able to participate; unlike the regular Roth IRAs, which can be established by individual taxpayers, Roth 401(k)s can only be offered by employers.
The Bottom Line
The Roth 401(k) is being touted by some as the best thing since sliced bread. But as with any financial planning tool, the degree of suitability of the Roth 401(k) will vary among taxpayers.
Many employers factor in the additional cost of separate accounting that applies to the Roth 401(k), as well as the usual administrative costs that apply to a traditional 401(k) plan, when deciding whether to adopt a plan with such features. As a result, many small business owners may be reluctant to adopt a plan with a Roth feature. Therefore, if you're interested in contributing to a Roth 401(k), your first step should be to find out whether your employer's plan includes that feature and, if so, your second step should be to check with your financial advisor to determine whether the Roth 401(k) suits your financial profile.