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Employee Benefits and Pensions

An analysis of the new Roth 401(k)/403(b) plans.

August 2008
by David Beausejour and Michael Lynch/The Tax Adviser

Since 2006, employers with 401(k)/403(b) plans have been allowed to offer their employees a qualified Roth contribution program which is commonly referred to as a Roth 401(k). Let’s look closer at the rules for Roth 401(k) contributions and distributions and we’ll demonstrate the difference in the after-tax returns between contributing to a traditional 401(k)/403(b) account and a Roth 401(k) account.

The Roth 401(k)/403(b) provisions, effective for tax years beginning on or after January 1, 2006, combine characteristics of Roth IRA and traditional 401(k)/403(b) plans in a single retirement program. Under the new provisions, employee contributions to a Roth 401(k) plan can be made in the same dollar amounts as under a traditional 401(k)/403(b) plan. Unlike a traditional plan, the contributions are not excludible from gross income. However, like a Roth IRA, qualified distributions from a Roth 401(k) plan are tax free and are not includible in gross income. The new provisions were set to expire for tax years beginning after 2010; however, the Pension Protection Act of 2006, P.L. 109-280 (PPA ’06), repealed the sunset provision as it applied to pensions and IRAs, thereby making the Roth 401(k) provisions permanent.

Qualified Distributions

The most significant benefit of a designated Roth account is that qualified distributions are not includible in gross income. The term “qualified distribution” has almost the same meaning as under the Roth IRA rules. A qualified distribution from a designated Roth account is one that is (1) made on or after the date on which the individual attains age 59½, (2) made to a beneficiary (or to the estate of the individual) on or after the death of the individual or (3) attributable to the individual’s being disabled. If a qualified distribution consists of employer securities, the individual’s basis in the securities is their fair market value at the time of distribution.

A distribution is not a qualified distribution if it is made within the five-tax-year period beginning with the earlier of either:

  1. the first tax year for which the individual made a designated Roth contribution to any designated Roth account established for that individual under the same applicable retirement plan or
  2. if a rollover contribution was made to the designated Roth account from a designated Roth account previously established for that individual under another applicable retirement plan, the first tax year for which the individual made a designated Roth contribution to such previously established account.

The plan administrator or other designated party for the 401(k)/403(b) plan is responsible for keeping track of the five-tax-year period. If a lump-sum nonqualifying distribution consists of employer securities, the net unrealized income thereon is (1) not includible in income, (2) not included in the basis of the securities and (3) capital gain when realized in a subsequent taxable transaction.

Nonqualifying Distributions

A nonqualifying distribution from a designated Roth account is treated much differently than one from a Roth IRA. Specifically, the ordering rules in Sec. 408A(d), which provide that the first distributions from a Roth IRA are a nontaxable return of contributions until all contributions have been returned, do not apply to nonqualifying distributions from a designated Roth account. Nonqualifying distributions from a designated Roth account are taxable under Sec. 402 in the case of a 401(k) plan and under Sec. 403(b)(1) in the case of a 403(b) plan.

For this purpose, a designated Roth account is treated as a separate contract under Sec. 72. Thus, if the nonqualifying distribution is made before the annuity starting date, the amount includible in gross income as an amount allocable to income and the amount not includible in gross income as an amount allocable to investment in the contract are determined under Sec. 72(e)(8). For nonqualifying distributions on or after the annuity starting date, the amounts are determined under Sec. 72(b).

Example: For instance, assume that an individual, before the annuity starting date, takes a nonqualifying distribution of $10,000 from a designated Roth account with a value of $25,000. Also assume that the individual previously made contributions of $20,000 to the account (thus, $5,000 of the account value is earnings). The amount includible in income is $2,000 ($5,000 ÷ $25,000 × $10,000) and the amount not includible in income is $8,000 ($20,000 ÷ $25,000 × $10,000).

Assessing the Benefits of a Roth 401(k) vs. a Traditional 401(k)

Many employers do not currently offer their employees the option of investing in a Roth 401(k). However, if an individual’s employer does offer this option, is the Roth 401(k) a better option than the traditional 401(k)/403(b)?

If an individual is currently in a lower tax bracket than the bracket they expect to be in upon retirement, the individual should consider a Roth 401(k). This could be the case if an individual gets divorced near retirement and does not remarry or if an individual’s spouse dies near the individual’s retirement and the individual does not remarry.

Example: For instance, in 2008, for a married individual filing jointly, the 25 percent bracket starts at $65,100; however, for a single individual, the 25 percent bracket starts at just $32,550. Required minimum distribution (RMDs) could also result in a higher tax bracket.

Other Benefits

Another benefit of the Roth 401(k) is to further an individual’s retirement investment diversification. If an individual currently participates in a traditional 401(k)/403(b) plan, the individual should consider participating in a Roth 401(k). Upon retirement, he or she could take RMDs from the traditional plan and roll over the Roth 401(k) into a Roth IRA. This allows the individual to diversify the funds into investments not offered by the 401(k)/403(b) plan and to continue the tax deferral on the investments. It would be advisable to take distributions from the Roth IRA only if absolutely necessary because, upon death, beneficiaries would receive the Roth IRA tax free under Sec. 102 and RMDs taken by beneficiaries would be tax free.

Another potential use of the Roth 401(k) that represents a significant advantage over the traditional plans is when an individual must withdraw funds to pay for a child’s or grandchild’s college education. Yearly tuition at many colleges currently exceeds $30,000. In 10 years, assuming five percent increases in tuition, annual costs at many colleges will be over $50,000. Parents and grandparents need to consider tax-advantaged investments in planning for their children’s or grandchildren’s education. Many taxpayers do not have the ability to maximize retirement contributions and properly fund their children’s or grandchildren’s education through Sec. 529 plans, Coverdell education savings accounts or other investments.

Conclusion

A fundamental tax planning principle is that you and your clients should try to avoid paying income taxes now and defer the payment of those taxes into future years if at all possible. The Roth 401(k) goes against this basic principle because the individual pays income taxes on the designated Roth contribution now rather than deferring the tax payment on elective contributions made to a traditional 401(k)/403(b). However, this additional tax cost is more than outweighed by the benefits of the Roth 401(k), including (1) diversifying retirement investments, (2) tax-free growth during an individual’s lifetime and possibly during a beneficiary spouse’s lifetime, (3) tax-free income on qualified distributions and (4) deferral of tax-free RMDs by rolling over the Roth 401(k) into a Roth IRA. Because of these significant benefits, individuals should seriously consider the Roth 401(k) in planning for retirement.

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David J. Beausejour, MST, J.D., CPA and Michael F. Lynch, MST, J.D., CPA are professors at Bryant University in Smithfield, RI. They are contributing writers for The Tax Adviser. Their views as expressed in this article do not necessarily reflect the views of the AICPA, The Tax Adviser or the AICPA CPA Insider™.

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