BOSTON – Details, details. The Roth 401(k) is now a reality. But that reality still comes with unanswered questions and cautionary notes — despite the IRS issuing "final" regulations about the new retirement plan in the closing days of 2005.
Read the 22-page report from the IRS (pdf)
The Roth 401(k) is a new type of retirement account — part Roth IRA and part 401(k) — designed especially for employees who believe their federal income tax rate will be higher when they retire than it is now.
In essence, those employees, including the self-employed, can sock away after-tax dollars into a tax-deferred account, much as they can with a traditional Roth IRA. As with the traditional 401(k), employees can defer up to $15,000 or $20,000 if age 50 or older in a Roth 401(k) and the money grows tax-free. And much like a Roth IRA, distributions are largely federal income-tax free if you meet requirements for a qualified distribution. (More on that later.)
In issuing its final regulations, experts say the IRS largely adopted the provisions of previously issued proposed regulations. But it did make some minor modifications and it did leave unanswered, at least for a bit, some questions that have experts trying to make educated guesses.
According to Forefield, a Marlboro, Mass., provider of financial education to financial advisers, the final regulations clarified the following:
— A "stand-alone Roth 401(k) plan" is not permitted. A Roth 401(k) or 403(b) plan must provide employees with a choice between pretax and Roth after-tax contributions.
— An employer can match an employee's Roth contributions, but those matching contributions will be pretax, and can't be allocated to the employee's Roth account.
— Roth contributions can be treated as catch-up contributions and may serve as the basis for plan loans. Employees, whose plans have a loan option, are allowed to borrow up to 50% of their vested account balance to a maximum of $50,000.
— An employer can use auto-enrollment in conjunction with Roth contributions. The plan must specify whether the automatic contributions will be Roth or pretax contributions.
"There were no great surprises," said Richard Giangregorio, a product manager responsible for Boston-based Pioneer Investments' Uni-k plan. "But we did get the promise of more regulations."
And given that promise, Giangregorio says employees evaluating whether to use Roth 401(k)s should at least be aware of some as yet unanswered questions that future IRS regulation will likely address.
First, there's the issue of how the IRS will tax nonqualified distributions from a Roth 401(k). "That's the million-dollar question," he said.
According a Forefield report on the subject, a qualified distribution (a tax-free distribution) is a payment from an employee's Roth 401(k) account that meets both of the following requirements: the payment is made after the employee turns age 59 1/2, becomes disabled, or dies, and the payment is made after the 5-year period that starts with the year the employee makes his or her first Roth contribution to the 401(k) plan, or what Giangregorio refers to as the "Roth clock."
Of note, an employee can roll his or her Roth 401(k) to another employer's Roth 401(k) and the Roth clock for will keep ticking based on the year of the initial contribution to the first Roth 401(k).
That's easy enough, but Giangregorio says there's a slight problem when an employee takes what is called a nonqualified distribution from his or her Roth 401(k), especially those that also contain pretax contributions from an employer. Those are distributions taken before an employee turns 591/2 or within the first five years on the Roth clock.
One school of thought suggests the IRS might first use a cost basis method and second an investment-earnings method to tax distributions. In that case, the original contribution or cost basis would be federal income tax free and the earnings when distributed would be taxable.
The other school of thought says the IRS would use a pro-rata method to tax the distribution. In that case, a portion of the distribution would be treated as contribution (nontaxable) and a portion, including the employer's pretax contribution, would be treated as earnings (taxable.) For his part, Giangregorio suggests the IRS will likely use the pro-rata method to tax nonqualified distributions. But it's still an open question.
Another open issue has to do with the so-called Roth five-year clock, because the IRS did not reveal who is responsible for keeping track of the clock. At present, Giangregorio says it's unclear whether the plan sponsor, the plan provider, the employer or the IRS is responsible for keeping track of the Roth clock. His best advice: when in doubt, the employee should keep track.
Giangregorio also says the regulations regarding what, if anything, happens to the five-year clock when an employee rolls their Roth 401(k) into a Roth IRA or from a Roth 401(k) to a Roth IRA and then to a new Roth 401(k) is still a bit of a mystery. The clock may start ticking anew or it may not. His best advice: leave the Roth 401(k) at your former employer if you can or, if able, roll it into a new employer's Roth 401(k) plan.
Other things to worry about?
Employees who leave their money in a Roth 401(k) will have to start taking minimum required distributions after turning age 701/2. To avoid this, Giangregorio recommends rolling the Roth 401(k) into a Roth IRA.
If an employee contributes too much to a Roth 401(k) in any particular year (more than $15,000 or $20,000 if age 50 or older), the employee must withdraw the excess by April 15 of the following year to avoid adverse tax consequences, according to a Forefield report. "If an employee fails to do so, the excess Roth 401(k) contributions, which normally would be tax free, will be subject to income tax (and a potential early distribution penalty) when distributed from the plan," the report says.
And last, the Roth 401(k) — unless extended — will expire at the end of 2010. The good news: for those age 50 and older there's a chance to sock away $100,000 to $250,000 (including employer contributions) in a Roth 401(k) while the getting is good.
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