Roth 401(k) Plans Frequently Asked Questions

Q. What is a Roth 401(k)?

A. A Roth 401(k) is part of a traditional 401(k) plan that allows employees to contribute after-tax dollars without being subject to taxes on future earnings. In contrast, regular 401(k) deferral contributions are funded with pre-tax dollars and the contribution and earnings are subject to taxes when the money is withdrawn. Roth contribution provisions can be added to plans beginning January 1, 2006.

Q. Why is the Roth 401(k) advantageous?

A. Although the concept is similar to a Roth IRA, the limitations are different. Unlike a Roth IRA, the Roth 401(k) has no limitations on income. For a Roth IRA, the IRS phases out contributions for those taxpayers earning more than $110,000 for a single filer and $160,000 for a married filer. The Roth 401(k) also allows contributions up to $15,000 for 2006 plus an additional $5,000 if the participant if over age 50. A Roth IRA would only allow contributions of $4,000 plus an additional $1,000 if over age 50. Please note that this limit is combined for regular 401(k) and Roth 401(k) contributions; that is, a participant would not be able to contribute $15,000 for the standard 401(k) and another $15,000 for the Roth portion. Lastly, by rolling over your Roth 401(k) to a Roth IRA after retirement, you can avoid the age 70 ½ required minimum distributions.

Q. Why would an employer want to institute Roth 401(k) contributions?

A. Employers have indicated that they will be more likely to start offering a Roth 401(k) if their employees demand it. Expectations are the employees who are in higher-income brackets will be those who will push for the Roth 401(k) more than any other group. Owners in high-income tax brackets will also benefit. Currently, individuals who are earning a high income may be barred from making contributions to a Roth IRA.

Q. What extra costs may be associated with implementing a Roth 401(k)?

A. Companies will need to make sure their payroll systems can handle this change. Also, plan amendments will have to be drawn up, employees will need to be educated about the change, and third party record keeping systems will have to be modified. New Summary Plan Descriptions will need to be prepared and distributed along with election forms for employees to indicate if they choose to make Roth contributions. Distributions will also become more complex as it will now be required to track income separately from contributions.

Q. When would a Roth 401(k) be preferable to a traditional 401(k)?

A. If a participant will be in a higher tax bracket at retirement than they are currently, then a Roth 401(k) plan will be the most advantageous plan for them. If a participant's tax bracket will be the same now as at retirement, both a traditional and a Roth 401(k) will produce the same benefit. If a participant's tax rate will be lower at retirement, a traditional 401(k) is the best option.

Q. How does a Roth 401(k) plan work?

A. Like traditional plans, anyone eligible for the plan would have to be eligible to elect to make Roth contributions. Employees can choose to defer to both the traditional 401(k) and the Roth portion of the plan. Employers can contribute a company match on the Roth contributions. At retirement or termination, the Roth 401(k) funds can be rolled over into a Roth IRA or another Roth 401(k). Loans can also be made available from the Roth contributions.

Q. Will Roth 401(k) contributions be included in testing?

A. Roth contributions will be included in the ADP (Average Deferral Percentage) test, as well as in the annual additions testing, general non-discrimination testing and top heavy testing.

Q. What are the withdrawal rules?

A. Roth 401(k)s will be similar to Roth IRAs in that the participant must have made at least one contribution to the account at least five years prior to the withdrawal in order for the withdrawal to be tax-free. In order to avoid other penalties, the withdrawal would have to made after the participant attains age 59 ½, dies or is disabled.

Q. Is the Roth 401(k) here to stay?

A. The provisions of the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA, which is the act that allows the Roth 401(k) to be adopted) actually expire (or sunset) at the end of 2010. Congress will decide whether to extend the Roth provisions. If the rules sunset, investors should be able to roll accounts into a regular Roth IRA, but new contributions may not be allowed.

Q. How does a Roth 401(k) compare to a Traditional 401(k)?

A.

	Traditional 401(k)	Roth 401(k)
Funding	Funded with pre-tax dollars	Funded with after-tax dollars
Matching Contributions	Allowed	Allowed, but would be a pre-tax contribution
Contribution Limits	$15,000 ($20,000 if age 50 or older) in 2006	$15,000 ($20,000 if age 50 or older) in 2006 but must include traditional 401(k) contributions to determine limit
Investment Earnings	Tax-deferred earnings (taxed at withdrawal)	Tax-free earnings
Taxation	Reduce current income tax Pay taxes at withdrawal	Pay taxes now Tax-free withdrawals at retirement
Access to Money	Can have access upon termination, death, disability, retirement, or at age 59 ½ (if plan provides)	Subject to same restrictions as traditional 401(k)
Tax-free Distribution	Not applicable	Must be: 1) a qualified distribution (age 59 ½, death or disability) AND 2) Roth 401(k) contributions must have been made to the plan at least 5 years ago to receive tax-free advantage
Minimum Required Distribution	At age 70 ½	At age 70 ½, but can be rolled over to a Roth IRA to avoid minimum required distribution rules that apply to qualified plans
Rollovers	Can be rolled over to a traditional IRA	Can be rolled over to a Roth IRA
Other factors to consider	N/A	Cannot begin prior to January 1, 2006. No law set forth to allow Roth 401(k) contributions to continue past 2010. Still waiting on IRS to clarify many Roth 401(k) regulations

Examples of Roth 401(k) Comparison:

Scenario 1 - Tax bracket is the same before and after retirement

	Regular 401(k) Only	Roth 401(k) Only
Income available to save	$10,000.00	$10,000.00
Current Tax Bracket	27%	27%
Retirement Tax Bracket	27%	27%
Pre-tax 401(k) Savings	$10,000.00	$0.00
Additional pre-tax savings due to deferrals	$3,698.63	$0.00
After tax amount to Roth 401(k)	$0.00	$10,000.00
Roth 401(k) contribution	$0.00	-$10,000.00
Regular 401(k) contribution	-$13,698.63	$0.00
Rate of Return	6%	6%
Number of years until retirement	20	20
Future Value of Roth 401(k)	$0.00	$367,855.91
Future Value of Regular 401(k)	$503,912.21	$0.00
Future Value of Regular 401(k) (after taxes)	$367,855.91	$0.00
Total Future Value	$367,855.91	$367,855.91

Scenario 2 - Tax bracket is higher after retirement

	Regular 401(k) Only	Roth 401(k) Only
Income available to save	$10,000.00	$10,000.00
Current Tax Bracket	27%	27%
Retirement Tax Bracket	33%	33%
Pre-tax 401(k) Savings	$10,000.00	$0.00
Additional pre-tax savings due to deferrals	$3,698.63	$0.00
After tax amount to Roth 401(k)	$0.00	$10,000.00
Roth 401(k) contribution	$0.00	-$10,000.00
Regular 401(k) contribution	-$13,698.63	$0.00
Rate of Return	6%	6%
Number of years until retirement	20	20
Future Value of Roth 401(k)	$0.00	$367,855.91
Future Value of Regular 401(k)	$503,912.21	$0.00
Future Value of Regular 401(k) (after taxes)	$337,621.18	$0.00
Total Future Value	$337,621.18	$367,855.91

Scenario 3 - Tax bracket is lower after retirement

	Regular 401(k) Only	Roth 401(k) Only
Income available to save	$10,000.00	$10,000.00
Current Tax Bracket	27%	27%
Retirement Tax Bracket	23%	33%
Pre-tax 401(k) Savings	$10,000.00	$0.00
Additional pre-tax savings due to deferrals	$3,698.63	$0.00
After tax amount to Roth 401(k)	$0.00	$10,000.00
Roth 401(k) contribution	$0.00	-$10,000.00
Regular 401(k) contribution	-$13,698.63	$0.00
Rate of Return	6%	6%
Number of years until retirement	20	20
Future Value of Roth 401(k)	$0.00	$367,855.91
Future Value of Regular 401(k)	$503,912.21	$0.00
Future Value of Regular 401(k) (after taxes)	$388,012.40	$0.00
Total Future Value	$388,012.40	$367,855.91