Proposed Regulations Breathe Life Into the Roth 401(k) Plan

- With Roth 403(b) Coming Next -


When first proposed in the House Republican’s Contract with America in the mid-1990s, the Roth IRA was referred to as the “American Dream Savings Account.”  Eventually, it was ushered into the American retirement saving landscape by the Taxpayer Relief Act of 1997 (“1997 Act”).  The concept is simple; an individual pays tax at the time contributions are made and, provided the funds are invested in the Roth IRA long enough, the investment and earnings are distributed tax free.  However, until now only those with an adjusted gross income (AGI) below a certain level ($110,000 for single/head of household individuals and $160,000 for married couples) have been eligible to participate in a Roth IRA.  That is all about to change.


The Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) permitted Roth contributions to be made to a traditional 401(k) or 403(b) plan, but not until January 1, 2006.  So, the concept effectively sat on the shelf for several years.  On March 2, 2005, the IRS issued proposed regulations for Roth contributions to 401(k) plans, rekindling interest in the subject.  The rules regarding Roth contributions to 401(k) plans are summarized below.  We expect similar regulations to be issued for Roth 403(b) shortly.


Roth contributions are treated like pre-tax elective contributions in many ways, for example:


                    Roth contributions are subject to the overall limitation on elective contributions ($15,000 for 2006).  This limitation applies to the total elective contributions, both Roth and pre-tax, that a participant can make to a plan in any calendar year.  However, this compares favorably to the maximum contribution that may be made to a Roth IRA (4,000 in 2006).


                    Roth contributions may be matched by employers on a pre-tax basis.  The IRS has not yet explained how safe harbor 401(k) plans will be affected.

                    Roth contributions may be rolled over to another qualified plan (as long as the qualified plan receiving the Roth contributions permits participants to make Roth contributions) or a Roth IRA.

                    Roth contributions are subject to non-discrimination rules and tests (ADP testing).  As previously mentioned, how safe harbor plan designs will work with Roth contributions must be determined by future IRS guidance.

                    The proposed regulations mandate that Roth contributions be accounted for in a separate account.  Employees will not be able to switch money from a Roth account to a pre-tax 401(k) account.

It remains to be seen who will be most interested in making Roth contributions to 401(k) or 403(b) plans and in what numbers.  It is anticipated that Roth contributions will be attractive to individuals who cannot currently contribute to Roth IRAs due to the AGI eligibility restrictions.  Also, any individuals who expect their tax rate to be higher in the future (at the time of their retirement distribution) may be interested in Roth contributions.  Some individuals might also view Roth contributions to their 401(k) or 403(b) plans as a desirable mechanism for potentially providing tax-free pre-retirement death benefits to their beneficiaries.  However, not everyone is a proponent of Roth contributions.  Reps. Ben Cardin, D-Md, and Rob Portman, R-Ohio, introduced pension legislation on April 29, 2005 that would eliminate Roth 401(k) plans, citing them as another plan in an already "swamped market" that will "lose significant amounts of revenue over time."


Whether employers will rush in large numbers to amend their plans to permit Roth contributions is yet to be seen.  Some may be reluctant because, like most EGTRRA provisions, those relating to Roth contributions to 401(k) and 403(b) plans “sunset” or expire after 2010.  Furthermore, adding the ability to make Roth contributions will probably require some cost and effort, including additional recordkeeping, communication materials and participant education, plan amendments, summary plan description modifications, and new enrollment, distribution, and other administrative forms. 


Nevertheless, in a formal survey at a recent seminar we sponsored, over one-third (1/3) of the audience indicated they were going to implement Roth contributions and one-half (1/2) were considering Roth contributions.  Financial institutions, third-party administrators, and other vendors to 401(k) and 403(b) plans will quickly develop products and services that will simplify the tasks and reduce the costs associated with maintaining Roth accounts.  Therefore, if you have not already given Roth contributions some thought, you will want to put this on your list of things to consider for 2006.


For additional information about the proposed regulations and how they may impact your business, please call or e-mail your contact in the Employee Benefits Group at Ice Miller.