Roth 401(k) Option - Effective 1/1/2006
See below for: When Does a ROTH Make Sense to a Participant?
A delayed feature of the 2001 tax act was the addition of a ROTH option to 401(k) plans. Similar to the ROTH IRA, ROTH contributions to a 401(k) are made on an ‘after-tax’ basis. When distributed, amounts attributable to ROTH contributions (including earnings) are not subject to tax. On the other hand, 401(k) contributions are made ‘pre-tax’ but the full amount of a distribution is subject to tax.
In simple terms, the inclusion of ROTH in a 401(k) provides employees the ability to designate that all or a portion of their 401(k) contributions are to be treated as ROTH contributions. The 401(k) limits remain unchanged. For 2006, the maximum 401(k) contribution is $15,000 with an additional $5,000 of catch-up for individuals age 50 or older. The inclusion of ROTH does not enable a participant to make additional contributions.
Unlike a ROTH IRA, there are no income limitations on the use of the ROTH 401(k). Thus, participants of any income level can make a ROTH contribution if permitted by their 401(k) plan.
The tax and payroll treatment of ROTH contributions differs from 401(k) contributions. 401(k) contributions are not subject to federal income taxes but are subject to employment taxes (FICA/Medicare). ROTH contributions are subject to federal income and employment taxes. Thus, participants who currently participate in a 401(k) plan and elect ROTH treatment will see a reduction in their net pay. This is because the ROTH contributions are subject to tax and the withholding of such taxes reduces net pay.
ROTH contributions are treated as 401(k) contributions for purposes of matching contributions and testing. Thus, designating a portion of 401(k) contributions as ROTH contributions has no impact on non-discrimination testing.
Amounts attributable to 401(k) contributions are only distributable from the plan upon termination of employment, attainment of age 59 ½, death, disability or hardship. A 401(k) plan may provide for distribution upon one or more of these events. Amounts attributable to ROTH contributions are subject to the same rules.
Amounts distributed from a 401(k) plan are often able to be rolled to another plan or IRA. Amounts attributable to ROTH contributions can be rolled to another ROTH 401(k) or to a ROTH IRA.
ROTH distributions which are not rolled-over are not subject to tax if they are ‘qualified’ distributions. A distribution is ‘qualified” if it satisfies the ‘five-year rule’ and is made for a ‘qualified purpose.’ The five-year rule is satisfied if the distribution is made after the end of the fifth tax year after the first ROTH contribution is made. The qualified purpose requirement is satisfied if the distribution is made after age 59 ½, disability or death.
If distributed without satisfying both the five-year and the qualified purpose rule, earnings on ROTH contributions are subject to tax. Such amounts may also be subject to the 10% early distribution tax.
Example. Employer adds ROTH feature to existing 401(k). In 2006, participant elects to designate all 401(k) contributions as ROTH contributions. Participant terminates employment in 2010 and elects to take a full distribution which is not rolled-over. The amount attributable to 401(k) contributions (those made prior to 2006) is subject to tax. The amount attributable to earnings on ROTH contributions is subject to tax because the five-year rule was not satisfied. The amount of ROTH contributions are not subject to tax (they were already taxed).
In the above example, the participant does not take a distribution in 2010. Rather, the participant waits until 2012 (when he is age 60) to take a distribution. In this case, the tax treatment of pre-2006 401(k) contributions is unchanged. However, all amounts attributable to ROTH contributions are not subject to tax (both the five-year rule and qualified purpose rule are satisfied).
The determination of whether ROTH treatment is more beneficial for a taxpayer depends primarily on his or her tax rate at the time of contribution and at the time of distribution. Under most scenarios ROTH treatment is more beneficial than 401(k) if the tax rate at distribution is more than that at contribution. Obviously, it is difficult to project what tax rates will be at the
time of distribution.
ROTH contributions are not required under a 401(k) plan. Each plan sponsor can determine whether or not to offer this feature. ROTH contributions can start January 1, 2006. A plan amendment will be required and certain compliance issues must be addressed. I attached a one-page summary which describes when a ROTH may be advantageous for a participant.
When Does a ROTH Make Sense to a Participant?
If my tax rate will be greater in retirement than it is now, I should make a ROTH election. Under a ROTH election, taxes are paid at the time of contribution. Thus, the relevant rate for ROTH purposes is the participant’s current tax rate. Under a 401(k), the participant defers all taxes until distribution. Thus, the relevant rate for 401(k) purposes is the tax rate the participant will pay in retirement. Obviously, it is difficult to determine the tax rate in retirement. It is possible to estimate the participant’s taxable income in retirement but it is difficult to estimate what tax rates will apply.
If my tax rate will be the same in retirement as now, 401(k) and ROTH treatment will be similar. This is ‘sometimes’ a true statement. Assume a 25% tax bracket now and in retirement. Assume the participant has $2,000 to contribute. Assume the participant contributes $1,000 as 401(k). Assume the participant wants to contribute the rest as ROTH. Since the ROTH contribution ($1,000) is subject to tax (25%), the participant pays the tax and contributes the rest to the ROTH ($750). Assume a 7% return on each investment. In 30 years, the 401(k) contribution will be worth $7,612 and the ROTH contribution will be worth $5,709. The participant takes a distribution from both. The 401(k) is subject to tax (25%) and the net result is $5,709. The ROTH is not subject to tax and the net result is also $5,709.
ROTH will be better if the participant wants to contribute as much as possible. Even when tax rates will be the same in retirement, when will 401(k) and ROTH not be similar? In the above example, the participant wanted to contribute $2,000. Assume the participant wants to contribute $20,000 or more. For 2006, the 401(k)/ROTH limit for this participant (age 35) is $15,000. Assume all the other facts in the above example.
With a ROTH election, the participant will pay tax (25%) on the entire $20,000, or $5,000. The participant will then contribute the remaining $15,000 as a ROTH contribution. In 30 years, the ROTH contribution will be worth $114,184. There will be no taxes due so the net result is $114,184.
With a 401(k) election, the participant will contribute the $15,000 maximum to the 401(k) and pay tax (25%) on the amount not contributed, $5,000, or $1,250. The participant will then invest the net amount ($3,750) in investments outside the plan. In 30 years, the 401(k) contribution will be worth $114,184 but will be subject to tax (25%) so the net result will be $85,638. The outside investment will also earn a 7% return but such return will be subject to tax each year. In 30 years, the outside investment will be worth $17,406 and no further taxes will be due. The net result of the 401(k) and outside investment is $103,044.
In this example, the ROTH outperforms the 401(k) because the participant is able to pre-pay the taxes on the ROTH instead of having the amount to pay such taxes built into the 401(k).
401(k) will be better if the participant will not satisfy the ROTH distribution requirements. In the above comparisons, the assumption is always that the participant satisfies the distribution requirements for the ROTH. If those requirements will not be satisfied, the 401(k) will always be a better choice.