2007-05-07

Plan sponsors can now offer employees additional retirement saving flexibility. Learn the details behind the IRS regulations permitting companies to allow employees to make Roth contributions to their 401(k) plans on an after-tax basis.

Plan sponsors may allow employees to make Roth contributions to their 401(k) plans, as of tax years beginning after 2005. Roth contributions are made on an after-tax basis, and qualified distributions of Roth contributions and associated earnings are tax-free, similar to Roth IRAs. A 403(b) plan may also permit Roth contributions.

In order for a 401(k) plan to permit designated Roth contributions, it must establish a program under which employees may elect to make designated Roth contributions in lieu of all or a portion of the pretax elective contributions employees are otherwise eligible to make under the plan.

Roth Versus Pretax Contributions--Which to Choose?

There are benefits to permitting both Roth and pretax contributions to a 401(k) plan. Roth contributions will be more attractive to some participants, while traditional pre-tax contributions will be more appealing to others. For some participants, the task of deciding which type of contribution they should make will be complicated, and the answer will depend on their individual circumstances. Generally, participants who believe they are in a lower tax bracket now than they will be at the time they retire may find Roth 401(k) accounts to be advantageous, but other factors should also be considered.

Plan sponsors may wish to consider providing company matching contributions on both Roth and pre-tax contributions in order to permit individual participants to freely choose which contribution type is best for them.

Interest in Roth 401(k) Accounts

Roth 401(k) accounts are continuing to attract attention. In Hewitt's Survey Findings: Hot Topics in Retirement 2007, almost one-third of surveyed employers that were not already offering Roth 401(k) accounts reported that they are very likely or somewhat likely to add them in 2007. Twelve percent already offer a Roth 401(k).

Regulations

On January 3, 2006, the IRS published final 401(k) regulations on Roth contributions. The final regulations generally follow previous proposed regulations, with some slight clarifications and modifications. The final regulations: 1) define designated Roth contributions; 2) describe the separate accounting requirement for designated Roth contributions; 3) reiterate that designated Roth contributions are to be treated like pre-tax contributions; and 4) describe how designated Roth contributions are treated with respect to nondiscrimination testing.

The final regulations are effective January 1, 2006, and are applicable for plan years beginning on or after January 1, 2006. For additional details, read Hewitt Bulletin: IRS Issues Final Regulations on Roth Contributions Under 401(k) Plans, linked to in the right column on this page.

On April 27, 2007, the IRS released final regulations that provide guidance on the taxation and reporting of distributions of Roth contributions from employer 401(k) plans. The final regulations generally apply to tax years beginning on or after January 1, 2007. The IRS finalized many of the rules it had proposed in January 2006, but also included a few modifications and clarifications in the final regulations. For example, the final regulations clarify that it is the actual year of distribution that determines whether the five-taxable-year period is satisfied, rather than the year to which the distribution relates. For more details, read Hewitt Bulletin: IRS Issues Final Regulations on Distributions from Designated Roth Accounts, linked to in the right column on this page.

EGTRRA and PPA

The Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) permitted plan sponsors to incorporate after-tax Roth contributions into 401(k) and 403(b) plans. The provision in EGTRRA that did so was set to expire in 2010. The Pension Protection Act of 2006 made the Roth provision (and many others) permanent, which may make more plan sponsors consider adding Roth accounts to their 401(k) plans.

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