Roth 401k - Rules and features proposed by the IRS

The Economic Growth and Tax Relief Reconciliation Act (EGTRRA) proposed in the year 2001 included a provision in the 401k plan that would allow participants of the plan to designate a part or the entire contribution as the Roth contribution. This will come into effect from January 2006 and the provision will remain till the end of 2010.

A Roth 401k Plan will include after-tax contributions unlike a general 401k plan which is concerned with pre-tax contribution. Taxes will be deducted from the participant's pay and then contributions will be made from the salary. But if the participant withdraws a certain amount from the total contribution after 59 and 1/2 years of age or due to death or disability, then he will not have to pay taxes under the condition that the distribution occurs after 5years of contribution.

The IRS has come up with some rules and regulations regarding the Roth 401(k) Plan. In order to designate a part or whole of the 401(k) Plan as the Roth contribution, a participant must satisfy the following criteria.

• The participant's contribution to the Roth 401(k) plan is not reversible, that is, once it is designated as Roth contribution, it cannot be changed.
  
  
• Any employer offering a Roth 401(k) Plan has to consider the contributions as wages subject to the withholding requirements at the time the participant will receive the total accumulated amount.
  
  
• The participant should use a separate account for the Roth contributions and the earnings and losses on the total amount.
  
  
• A 401(k) Plan must have provision to allow for the Roth contributions.

The designated Roth contributions must comply with the rules applied in case of pre-tax contributions under a 401(k) Plan.

• The Roth contributions must follow the restrictions on non-forfeitability and distribution applied to 401(k) Plan contributions.
  
  
• The Roth contribution must be included within the regular 401(k) Plan contribution so that these add up to the annual contribution limit which is equal to $15,000 for the year 2006. A participant cannot contribute $15,000 to a regular 401(k) Plan and another $15,000 to a Roth 401(k) Plan.
  
  
• The Roth contributions must be included within the pre-tax contribution (for 401k Plan) which is considered for the Actual Deferral Percentage (ADP) nondiscrimination test.
  
  
• The Roth contributions cannot be withdrawn before 59 and ½ years except for conditions of financial hardship. The contributions should follow the minimum distribution rules of 401(k) Plan.

All participants can make the Roth 401(k) contributions regardless of their gross income. This is where the Roth 401(k) plan differs from a Roth IRA which cannot be used by higher income employees. Roth 401(k) contributions can be rolled over to a Roth IRA provided the participant no longer remains an employee. The amount rolled over to the Roth IRA will not be subject to the minimum distribution rules as followed in a 401(k) plan.

A Roth 401(k) plan may have certain benefits but whether a participant would designate a part of his 401(k) contribution as Roth contribution or continue with pretax contribution, depends on his effective tax rate during his retirement period – whether the tax rate during distribution is higher than at the time of contribution and also the subsequent tax laws.

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