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New Guidelines for Roth 401(k) Plans

The Roth 401(k) plan made its long-awaited debut on January 1, 2006. However, this new “hybrid” retirement plan has not received the overwhelming response initially anticipated. Now the IRS has issued final regulations that may further dampen enthusiasm for this new type of retirement plan.

Background: The Roth 401(k) plan was authorized by the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA). It combines some of the elements of traditional 401(k) plans with aspects of Roth IRAs (individual retirement accounts).

As with a regular 401(k) plan, an employee can elect to defer salary to the Roth 401(k), but in this case the contributions are made on an after-tax basis. There is no current tax on any accumulations within the Roth 401(k). As with a Roth IRA, qualified distributions may be completely tax-free after five years if they are paid:

*After the recipient reaches age 59½;

*For a qualifying first-time home purchase expense;

*At or after the death of the contributor; or

*On account of disability.

Distributions from Roth 401(k) accounts will only be permitted to be rolled over into other Roth accounts, whether it is another 401(k) plan or a Roth IRA.

The IRS issued proposed regulations in 2005 that established some of the basic requirements for administration of Roth 401(k). For instance, employees must make an irrevocable designation of a Roth contribution at the time of the deferral. Even more important, Roth 401(k) contributions must be maintained in a separate account from other 401(k) contributions. Separate accounting will apply to the contributions and earnings until all Roth contributions have been distributed. These extra administrative responsibilities have discouraged many employers from amending their existing 401(k) plans to accommodate the Roth 401(k) option.

The new final regulations clarify the rules and also include a couple of surprises. Key point: The new regulations do not establish separate “ordering rules” for distributions from Roth 401(k) accounts. In contrast, distinct ordering rules are in place for Roth IRA distributions, depending on the nature of the source of the funds (i.e., whether a distribution comes from a regular contribution, a rollover or income). This only adds to the administrative complexity.

Furthermore, it is noteworthy that lifetime distributions from a Roth 401(k) plan are mandatory. There are no minimum required distributions for Roth IRAs.

As you might expect, the jury is still out on the long-term viability of the Roth 401(k) plan. Do not make any hasty decisions concerning this new type of plan. It is strongly recommended that you seek professional assistance concerning all of your retirement planning needs.

 

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