Proposed regulations by the Internal Revenue Service have been issued to make Roth 401(k) Plans effective January 1, 2006. Final regulations will be needed before all details of the plan will be available.

What we know

Contributions

Roth 401(k)’s will be similar to Roth IRA contributions in that the contributions are made on an after tax basis. When withdrawals occur, both the principal and the earnings will come out tax free if withdrawn after age 59 ½ and satisfies the 5 year rule . The Roth contributions are classified as employee deferrals.

The 401(k) may choose to allow Roth contributions or not. There are three different 401(k) plan designs which may be available:

1. All Pre-tax 401(k)
2. All ROTH 401(k)
3. Both Pre-Tax and ROTH 401(k) with the participant selecting their deferral to each account.

Roth 401(k) accounts will NOT be subject to the income limitations applicable to Roth IRA’s (currently $160,000 adjusted gross income for married and $110,000 for singles).

Although, Roth IRA’s are limited to $4,000 in 2006, the regular salary deferral contribution to pre-tax and/or Roth 401(k)’s will be $15,000, plus catch up of $5,000 combined. Therefore, the amount available to contribute to the Roth 401(k) is much higher than the Roth IRA.

Distributions

Qualified distributions from a Roth account are more complicated in their tax consequences than the regular 401(k) pretax contributions. The Roth contributions are generally tax free on both the principal and the earnings at distribution providing they meet the following requirements:

• Made after the participant reaches age 59 ½
• Made to a beneficiary after death of a participant
• Due to a disability of the participant
• Holding period – five calendar years from the first taxable year the participant made a contribution

If the Roth monies are distributed in cash prior to the above requirement being met, the earnings will be subject to income taxation. And unlike ROTH IRAs, ROTH 401(k) plans are subject to the minimum required distribution rules. For example, you generally must begin distributions at age 70 ½ unless the participant continues working.

The Roth 401(k) contributions can be rolled over to another Roth account upon the participants termination without penalties or taxes.

Testing

Roth 401(k)’s will still be subject to the discrimination testing requirements for the highly compensated employees (HCE’s).

What we don’t know

Documents

Roth provisions will need to be reflected in the plan document. However, additional guidance is necessary and expected for the appropriate language.

Administrative Questions

There are a number of administrative issues to be resolved and clarified in the final regulations. Many of these questions relate to the investment companies, payroll companies, and administrative firms’ systems allowing accounts with different tax implications and the processing.

Is the Roth 401(k) right for your company?

This will depend on many factors including:

• Employee Education and Interest – Will your employees want and understand after tax contributions? Is it better to contribute to the Roth or pretax contribution? There is not easy answer to this question. Many factors will determine the answer to this, such as age, when access to the account is needed, retirement age, etc. Many younger employees and those who do not need current tax deductions will benefit with the tax free accumulation of the Roth accounts. Employee education meetings and written information will need to be provided to participants to make an educated decision.
• Administration – Contributions of Roth monies must be distinguished separately from pretax contributions. Administration will be somewhat more complicated. Administrative costs will likely increase. New enrollment forms will need to be completed.

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The information contained in this communication is not written or intended as tax or legal advice. The information provided herein may not be relied on for purposes of avoiding any federal tax penalties. Individuals are encouraged to see tax or legal advice from an independent professional advisor.