Taxing Issues …

Your Retirement: Are Roth plans right for your organization?

By Eddie Adkins and Harvey Berger

     As you read this article, you might find yourself wearing two different hats: first, as an employer who makes decisions about employee benefit plans, and second, as an employee who participates in those plans. In this article are both perspectives interchangeably as both employer and employee.
     Starting in 2006, if you provide either a 401(k) or 403(b) plan for your employees, then you can allow the employees to make Roth contributions to the plan. You are probably familiar with the concept of a Roth contribution, because Roth IRAs have been in existence for several years. Like Roth IRA contributions, the contribution is made to the 401(k) or 403(b) plan on an after-tax basis. When the contribution and its accumulated earnings are distributed from the plan some day in the future, the distribution is not taxed.
     That is where the similarity to a Roth IRA largely ends. To start, the maximum Roth IRA contribution you can make in 2006 is only $4,000, plus a $1,000 so-called “catch-up” contribution if you are age 50 or older. The maximum Roth contribution for 2006 in a 401(k) or 403(b) plan is the considerably greater amount of $15,000. Like the Roth IRA, you can also make a catch-up contribution if you are at least age 50 in the amount of $5,000. In addition, Roth IRA contributions are reduced and even completely eliminated when income exceeds a certain amount. Fortunately, there are no such income limits for Roth contributions.
     So far, Roth contributions sound like very good news. However, it is not quite as easy as it sounds. First, the limits above are the combined limits for both pre-tax and Roth contributions, so you have to make a choice between the two types of contributions. For example, if you want to make a $12,000 pre-tax contribution, then your Roth contribution is limited to $3,000, ignoring the possibility of making a catch-up contribution.
     Second, the offering of Roth contributions is completely optional on the part of employers. As an employer, you might be reluctant to offer them. As will be discussed later, Roth contributions complicate the administration of a plan. In addition, the availability of Roth contributions is currently scheduled to expire on December 31, 2010. Thus, it could be more trouble than it is worth to set up a plan to accept Roth contributions for only a few years. One can hope that Congress will extend Roth contributions, but there is certainly no guarantee.
     There is no reason for an employer to offer Roth contributions unless employees derive more benefit from them than from pre-tax contributions. Thus, a comparison of the two alternatives is vital not only to individual employees, but also to the employer in trying to decide whether to offer Roth contributions.
     Suppose you are trying to decide between contributing $1,000 to a plan on a pre-tax basis or Roth (after-tax) basis. Let’s assume that your current income tax rate is 25 percent. If you make the contribution on a pre-tax basis, you will contribute the full $1,000. If you make a Roth contribution, that you’ll have to pay $250 in income taxes, so you will have only $750 to contribute to the plan. Which approach makes more sense?
     To help answer that question, let’s assume that the contribution is invested for 10 years at an annual investment return of 6 percent. At the end of the 10 years, you withdraw the money from the plan. How much will you have if you chose to make a $1,000 pre-tax contribution, after paying the taxes that are due on the distribution? Alternatively, how much will you have if you made a $750 after-tax contribution, with no taxes due on the distribution? The answer depends on your income tax rate at the time of the distribution, as follows:
     If your tax rate is still 25 percent at the time of the distribution, then there is no difference between the two alternatives.
If your tax rate is greater than 25 percent at the time of the distribution, then the Roth contribution will yield a greater after-tax amount.
     If your tax rate is less than 25 percent at the time of the distribution, then the pre-tax contribution will yield a greater after-tax amount. The accompanying table compares the two alternatives.
     As the table indicates, a Roth contribution is a good choice if you believe that your tax rates will increase in the future. For example, younger workers who are currently in a low tax bracket are good candidates for Roth contributions. The higher your tax rate goes in the future, the better the Roth contribution.
     You might also want to consider the fact that Roth distributions are not included in the calculation to determine whether a portion of your Social Security benefits are taxable. Another advantage of Roth contributions is that they can help you to minimize the required distributions that plans must pay to you starting at age 70-1/2. Although Roth contributions are subject to these minimum distribution rules, you can roll over the Roth contributions to a Roth IRA, where they will not be subject to the minimum distribution requirements.
     Although Roth contributions might sound good to you, you will want to steer clear of them under certain circumstances. Specifically, Roth distributions are tax-free only if certain conditions are met. If you do not meet those conditions, then the investment earnings on the Roth contributions are subject to tax. If this occurs, you will find that you would have been better off if you had made pre-tax contributions. Thus, it is important to turn our attention now to these requirements.
     For your Roth distribution to be tax-free, it must be a so-called “qualified” distribution. To be a qualified distribution, the distribution cannot be made until you have attained age 59-1/2. An earlier distribution is permitted in the event of death or disability.
     In addition, you must have had Roth contributions in the plan for at least five years. In deciding whether to make Roth contributions, you will need to carefully consider whether you will be able to meet this five-year requirement. The five-year period begins on the first day of your tax year in which you first make a Roth contribution to the plan.
     For example, if you first make a Roth contribution in November, 2006, your five-year period begins on January 1, 2006. The five-year period ends when five consecutive tax years have passed. Thus, continuing the example, your five-year period would end on December 31, 2010.
     You never have to start over in determining your five-year period for a plan. For example, suppose you previously made Roth contributions to your plan, but you received a distribution of all the Roth contributions. Now, you decide to make additional Roth contributions.
     Your five-year period does not start over; instead, it goes all the way back to the beginning of the tax year in which you first made Roth contributions to the plan.
     There is a special, favorable rule for calculating your five-year period when you previously made Roth contributions to another plan (such as a prior employer’s plan), and now you roll those contributions over to your employer’s plan. In this case, your five-year period goes all the way back to the beginning of the tax year in which you first made Roth contributions to the prior plan.
     As an employer, a key issue is whether you want to take on the additional complexity brought about by Roth contributions, especially when you do not know the extent to which your employees will take advantage of this feature. It is too soon to tell how many employers will decide to allow Roth contributions, but very few have done so thus far.
     Of course, it was not available until this year, and the Internal Revenue Service has only recently issued guidance that many employers felt was necessary before giving serious consideration to allowing Roth contributions. One major human resources consulting firm has reported that only 6 percent of its large clients have adopted Roth contributions.
     General Motors made news recently when it announced that will offer Roth contributions to 140,000 workers starting in the summer of 2006. Interestingly, some of the early adopters are financial services firms, such as Vanguard and A.G. Edwards, perhaps indicating that financially sophisticated employees may feel that Roth contributions are beneficial, and are pushing for them.
     If you offer Roth contributions in your plan, one of your first tasks will be to communicate this to your employees, including the advantages and disadvantages of the contributions.
     You will also need to make sure that your systems can accommodate the contributions. For example, since Roth contributions are made on an after-tax basis, your payroll system must apply Federal and state income tax withholding to the contributions. It will also withhold FICA and Medicare as it does even for pre-tax plan contributions. All of these taxes will have to come out of other income, such as regular wage payments.
     Your plan’s record keeping system must track Roth contributions separately from other contributions. You are required to keep a record that allocates the Roth account between the after-tax contributions and the investment earnings. This is the case because if a Roth distribution does not meet the requirements for a qualified distribution discussed above, the investment earnings are subject to tax.
     In fact, you have to prorate the distribution between a tax-free return of the contribution and the taxable investment earnings. For example, suppose you make a $1,000 nonqualified distribution to an employee. Suppose that the employee’s total Roth account is $10,000, consisting of $9,400 of contributions and $600 of earnings. Of the total $1,000 distribution, $940 will be nontaxable, while the $60 attributable to investment earnings will be taxable.
     You must also keep track of the five-year period, discussed above. Each employee has his or her own five-year period, depending on the year in which he or she first made a Roth contribution to the plan. If your plan accepts rollovers of Roth contributions from other plans, then you will need to be able to track the five-year period based on the time when the employee first made a Roth contribution to the prior plan. It is helpful that the IRS’s proposed regulations require the prior plan to tell you the beginning date of the employee’s five-year period in that plan.
     Fortunately, Roth contributions are treated just like pre-tax contributions in several respects, which eases plan administration challenges. For example, Roth contributions are included in a 401(k) plan’s nondiscrimination test in the same manner as pre-tax contributions. Roth contributions are subject to the same distribution restrictions as pre-tax contributions.
     Roth contributions are available for loans, if the plan so permits. Roth contributions can be commingled with other contributions for purposes of making investments; there is no need to maintain a separate asset pool.
     Roth contributions might provide a greater retirement accumulation for you than pre-tax contributions, depending on what happens to tax rates in the future. Thus, in making a decision as to whether to make Roth contributions, you must consider what you believe will happen to rates in the future.
     As an employer, you could be asked by your employees to add this feature to your plan, especially if your employees are financially sophisticated. You will have to weigh the potential benefits to your employees against the additional plan administration costs, especially in light of the fact that Roth contributions might no longer be permitted after 2010.
Harvey Berger, CPA, is a partner and national director of not-for-profit tax services in Vienna, Va., for the accounting and management consulting firm Grant Thornton LLP. His email address is: hberger@gt.com. Eddie Adkins is compensation and benefits tax practice leaders in Grant Thronton’s Washington, D.C. office. His email is eadkins@gt.com