IRS Proposes Regulations for Roth 401(k) Programs Starting in 2006

The 2002 tax law (known as "EGTRRA") included a provision allowing qualified 401(k) plans and 403(b) plans to permit participants to designate some or all of their contributions as "Roth contributions" for plan years beginning in 2006 or later. The IRS recently published its first round of guidance on Roth contributions. (The IRS only addressed Roth 401(k) contributions, so the rest of this Alert will not discuss 403(b) plans.) We expect that this is going to cause many employers to begin exploring the issues that would be involved in adding a Roth contribution feature to their plans. Note, however, that plans are not required to allow participants to designate their contributions as Roth contributions.

Unlike regular pre-tax 401(k) contributions, a Roth contribution is an "after-tax" contribution that will be taxed to the participant at the time it is deducted from his or her pay. However, if the Roth contributions, and the accumulated earnings on them, are distributed after age 59 1/2, or due to death or disability, they will be exempt from tax, provided the distribution occurs at least 5 years after the participant began making Roth contributions.

To be Roth contributions, elective 401(k) contributions will have to meet all of the following requirements:

• The participant's contribution election has to designate the contribution irrevocably as a Roth contribution.
  
• The employer has to treat the Roth contributions as wages subject to the applicable withholding requirements at the time the participant would have received the amount in cash.
  
• The Roth contributions, and the allocable share of earnings and losses on those contributions, must be maintained in a separate plan account.
  
• The 401(k) plan must explicitly permit Roth contributions (although the deadline for actually amending plans has not yet been established).

In other respects, Roth contributions are subject to the same rules that apply to other elective deferrals. In the case of a 401(k) plan, this means that the Roth contributions must be included with the regular 401(k) elective deferrals in the nondiscrimination testing, must be nonforfeitable when made, are aggregated with the regular 401(k) elective deferrals for purposes of the annual contribution limits, cannot be withdrawn before age 59 1/2 except for financial hardship, and have to comply with the minimum distribution rules. If the plan allows it, a participant could designate part of his or her elective contributions as Roth Contributions and part as regular 401(k) contributions.

Unlike Roth IRAs, Roth 401(k) contributions will be available to all participants, regardless of their gross income. This may lead to pressure on employers for addition of the Roth feature coming from higher-income participants who otherwise cannot qualify for the tax-free distributions that are viewed as a major benefit of a Roth IRA. Roth 401(k) contributions can be rolled over to a Roth IRA when the participant leaves employment. Because a Roth IRA that receives such a rollover would not be subject to minimum distribution requirements during the participant's lifetime, this ability to defer distributions until death may create an attractive planning opportunity for some participants. Note, however, that there is no provision for converting existing regular 401(k) accounts into Roth accounts.

A participant's decision whether to designate part or all of his or her contributions as regular or Roth contributions is likely to be fairly complex, involving such things as predictions of future changes in the tax laws and the participant's effective tax rate during his or her retirement years. Employers considering adding this feature to their plans will likely have to focus on how it can be communicated to the participants in an understandable manner without causing confusion or discouraging participation in the plan.

The decision whether to amend a 401(k) plan to allow designation of Roth contributions will also require consideration of the changes that would need to be made in the employer's payroll system to handle the different tax treatment of the payroll deductions (including the different tax withholding and W-2 reporting), and in the plan's recordkeeping system to maintain the separate Roth contribution account and to handle the different tax reporting of distributions from that account.

Despite the complexities that Roth contributions will add to 401(k) plan administration, we expect that many employers will seriously consider adding the Roth feature to their plans beginning in 2006. This development will likely be different than the EGTRRA provision allowing "deemed IRAs" in qualified plans, which took effect two years ago and which has generated very little interest from employers.