Sample. Table of Contents. Introduction What are Roth deferrals and how do they differ from regular deferrals (pre-tax) to a 401(k) plan?...

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2 Table of Contents Introduction... 1 What are Roth deferrals and how do they differ from regular deferrals (pre-tax) to a 401(k) plan?... 2 Is it better for a plan participant to make Roth deferrals or regular deferrals?... 2 Must a 401(k) plan offer the option of making Roth deferrals?... 6 May a 401(k) plan permit both regular deferrals (pre-tax) and after-tax Roth deferrals?... 6 What are the primary differences between Roth deferrals to a 401(k) plan and an individual s contributions to a Roth IRA?... 7 What is the maximum amount of Roth deferrals that an employee may make to a 401(k) plan?... 7 May a participant who has attained age 50 by the end of a calendar year make catch-up contributions during the calendar year that are Roth deferrals?... 8 When can distributions of Roth deferrals and earnings be made?... 8 Can Roth deferrals to a 401(k) plan be used to make participant loans or to purchase life insurance?... 9 What is a qualified distribution?... 9 What happens if a distribution is not a qualified distribution?... 9

3 Are Roth deferrals to a 401(k) plan subject to nondiscrimination testing? May Roth deferrals be made to a safe harbor 401(k) plan? May Roth deferrals be matched by the employer? May a participant who makes Roth deferrals to a 401(k) plan also receive a profit sharing plan contribution? How does an employee indicate the intention to make Roth deferrals rather than regular deferrals? How does a 401(k) plan administrator distinguish between regular deferrals and Roth deferrals? When must a 401(k) plan distribute Roth deferrals (including earnings)? May a participant avoid having to commence distributions of Roth deferrals (and earnings) at age 70½ (or if later, after the participant retires)? May a participant roll over a distribution from the participant s Roth deferral account? May a participant roll over a distribution from a Roth IRA into a 401(k) plan? May a retirement plan other than a 401(k) plan have Roth accounts?... 14

4 Introduction Sponsors of 401(k) plans may now allow employees to make Roth deferrals to their plans. Roth deferrals to a 401(k) plan are the same as regular deferrals (pre-tax), except for the tax consequences. The same operational requirements and distribution restrictions that apply to regular deferrals also apply to Roth deferrals. Based on the popularity of Roth IRAs, it is expected that the ability to make Roth deferrals to a 401(k) plan will be a popular plan design. This pamphlet will address the most common questions relating to this new retirement plan option. 1

5 What are Roth deferrals and In a traditional how do they differ from 401(k) plan, regular deferrals (pre-tax) participants may to a 401(k) plan? elect to defer a portion of their current pay to the plan. These deferrals (known as regular deferrals (pre-tax) ) are excluded from taxable income when deferred, but are taxed, along with earnings, when distributed from the plan. Thus, tax on the regular deferrals and earnings is postponed. Roth deferrals are made from after-tax pay. However, there is no taxation of the earnings attributable to the Roth deferrals when a qualified distribution of the Roth earnings is made from the plan. The result is that a distribution of the Roth earnings may be tax-free, rather than tax-postponed. Is it better for a plan participant to make Roth deferrals or regular deferrals? There is no simple answer to this question. And, because the answer is not simple, employee communication may be one of the drawbacks to permitting Roth deferrals in a 401(k) plan. Whether a participant will be better off making Roth deferrals rather than regular deferrals will depend on numerous factors. In general, the longer Roth deferrals remain in the plan, the more favorable they are (i.e., the Roth deferrals may result in 2

6 more tax savings than regular deferrals). However, this is not always the case, so several things must be considered before making a decision. Ability to afford higher contributions One of the most important items to think about is whether the decision to contribute regular deferrals or Roth deferrals will affect the amount of salary deferrals that a participant can afford to contribute to the plan. If a participant can afford to contribute the same dollar amount of salary deferrals, regardless of whether they are regular deferrals or Roth deferrals, then that means Roth deferrals may be more advantageous. This is because Roth deferrals are generally worth more than regular deferrals, since tax has already been paid on the Roth deferrals. The ability to afford higher contributions becomes more important in two situations: (1) when a plan provides for a matching contribution, or (2) when a participant wants to contribute the maximum amount allowed by the plan or by the law. In the case of matching contributions, it is generally best to contribute the maximum amount that will be 3

7 matched under the plan. If a participant is not able to contribute enough Roth deferrals to receive the maximum matching contribution, then making a larger contribution with regular deferrals may be the better choice. Example: Jack earns $50,000 per year. If his plan provides a matching contribution equal to 100% of his deferrals up to 4% of pay, Jack must contribute $2,000 to receive the full matching contribution. If he contributes $2,000 as regular deferrals, then his taxable pay for the year will be $48,000. But, if he contributes the $2,000 as a Roth deferral, then his taxable income remains at $50,000. He would owe tax on a larger amount of income, and this tax would result in lower take-home pay. If he cannot afford to lower his take-home pay by the amount of tax on the $2,000 Roth deferral and would contribute less than $2,000 as a Roth deferral, then he may be better off contributing the $2,000 as a regular deferral in order to maximize his matching contribution. Similarly, if a participant is trying to contribute the 4

8 maximum amount permitted by the plan and by the law, then making Roth deferrals may be the better choice. This is because the Roth earnings may be distributed tax-free (if the requirements for a tax-free distribution are met). The larger the amount of the contribution, the larger the amount of potential tax-free earnings. Current and future tax rates Another item to think about is the federal income tax rate at the time of the contribution, compared to the expected tax rate at the time of distribution. Regular deferrals are taxed when distributed. Roth deferrals are taxed when these are made to the plan. If a participant believes that his or her tax rate will be lower in the future when distributions are received from the plan, then making regular deferrals to the plan may be the better choice. Conversely, if it is expected that the tax rate will be higher (e.g., because of changes in the tax law, fewer deductions and/or higher taxable income) when distributions are received, then making Roth deferrals may be the better choice. 5

9 When the deferrals will be withdrawn When deciding on the type of contribution to make, a participant also must consider when the contribution will be withdrawn from the plan. If the contribution will be withdrawn before the conditions of a qualified distribution are satisfied, then making regular deferrals may be the better choice. Must a 401(k) plan offer the No. This is a plan option of making Roth design issue. It is deferrals? the choice of the 401(k) plan sponsor whether employees will be permitted to make Roth deferrals. May a 401(k) plan permit both regular deferrals (pretax) and after-tax Roth deferrals? Yes. The 401(k) plan sponsor may permit employees to make either of these deferrals. However, if the plan permits Roth deferrals, the plan also must permit regular deferrals (pre-tax). For simplicity, some sponsors may design their 401(k) plans to only permit participants to choose one type of deferral for a plan year. 6

10 What are the primary There are two key differences between Roth distinctions: deferrals to a 401(k) plan (1) the different and an individual s contribution contributions to a Roth IRA? limits, and (2) the individuals who are eligible to make the contributions. The maximum amount that may be contributed to a 401(k) plan (either as Roth and/or as regular deferrals) is larger than the amount that may be contributed to a Roth IRA [for 2007, $15,500 to a 401(k) plan ($20,500, if the employee is able to make catch-up contributions) vs. $4,000 to an IRA ($5,000, if the individual is able to make catch-up contributions)]. In addition, an individual may be precluded from making a Roth IRA contribution if the individual has gross income in excess of certain dollar amounts. This restriction does not apply to Roth deferrals to a 401(k) plan. There are no restrictions on an employee s ability to make Roth deferrals to a 401(k) plan solely because of the employee s income. What is the maximum Even though the amount of Roth deferrals tax effect of Roth that an employee may make deferrals differs to a 401(k) plan? from regular deferrals, both are elective deferrals for purposes of the law. Accordingly, there is no distinction between the two types of deferrals in determining the 7

11 contribution limits (as well as certain other operational requirements). The deferral limit that applies to regular deferrals also applies to Roth deferrals. The 2007 calendar-year limit is $15,500 (this may increase in future years based on cost-of-living increases). Furthermore, this maximum limit applies to the total of all Roth deferrals and regular deferrals to any 401(k) plan (or 403(b) plan). May a participant who has Yes. The catch-up attained age 50 by the end rules that permit a of a calendar year make participant who catch-up contributions has attained age 50 during the calendar year by the end of the that are Roth deferrals? calendar year to make additional regular deferrals, also apply to Roth deferrals. However, the catch-up limit ($5,000 for 2007) for a particular calendar year is determined by totaling all Roth deferrals and regular deferrals. When can distributions of Because Roth Roth deferrals and earnings deferrals to a be made? 401(k) plan are treated in the same manner as regular deferrals, the same distribution restrictions apply. In general, a distribution may only be made upon a hardship, the attainment of age 59½, death, disability, or termination of employment. 8

12 Can Roth deferrals to a Yes. Roth 401(k) plan be used to deferrals in a make participant loans or to 401(k) plan are purchase life insurance? subject to the same rules that apply to regular deferrals in a 401(k) plan. Unlike amounts in a Roth IRA, Roth deferrals in a 401(k) plan may be used to make participant loans and to purchase life insurance for the participant. These are optional provisions that a sponsor may permit. What is a qualified In order to avoid distribution? the taxation of earnings attributable to Roth deferrals, a distribution from the plan must be a qualified distribution. A qualified distribution is a distribution that is made after the participant attains age 59½, becomes disabled or dies. In addition, a qualified distribution occurs only if the distribution is made after the end of the five-year period beginning with the calendar year in which the participant first made a Roth deferral to the 401(k) plan (or to a prior plan if there is a rollover of Roth deferrals from the prior plan to the 401(k) plan). What happens if a If a distribution distribution is not a from a qualified distribution? participant s Roth deferral account is not qualified, then the portion of the distribution that represents earnings 9

13 on the participant s Roth deferrals is taxable. In other words, any distributed earnings attributable to Roth deferrals lose their nontaxable character when a distribution is not qualified, which is the primary benefit of making Roth deferrals. In addition, if a distribution is not qualified, then the distribution of these taxable earnings may be subject to a 10% premature distribution penalty tax. Are Roth deferrals to a Yes. The 401(k) plan subject to nondiscrimination nondiscrimination testing? test that applies to these deferrals is called the ADP test (Actual Deferral Percentage test). This ADP test compares the deferrals (including both regular (pre-tax) and Roth deferrals) of highly compensated employees and non-highly compensated employees. If the ADP test fails, then either the plan must distribute some of the deferrals to the highly compensated employees or the plan sponsor must make additional contributions to the non-highly compensated employees. May Roth deferrals be made Yes. A safe harbor to a safe harbor 401(k) plan? plan satisfies the 401(k) nondiscrimination requirement (ADP test) by providing certain employer contributions and satisfying other requirements. Roth deferrals would be eligible for any employer matching 10

14 contributions provided by the plan, if the plan satisfies the safe harbor requirement with matching contributions. May Roth deferrals be Yes, a plan matched by the employer? sponsor may design the plan to provide that deferrals will be matched, including Roth deferrals. However, employer matching contributions are pre-tax contributions. If matching contributions are not rolled over when distributed, then the distribution of the matching contributions is taxable as ordinary income (not tax-free) and may be subject to the 10% premature distribution penalty tax. May a participant who Yes. A 401(k) plan makes Roth deferrals to a may permit any 401(k) plan also receive a combination of profit sharing plan deferrals (regular contribution? (pre-tax) or Roth), matching contributions, or profit sharing contributions. The qualified plan rules that limit the total contributions that may be made to any participant s account would apply. How does an employee An employee indicate the intention to makes a deferral make Roth deferrals rather election. As part than regular deferrals? of the election, the employee must designate which type of deferral is to be made. Once a deferral is made to 11

15 the plan based on the participant s election, it is irrevocable. In other words, a deferral goes into a 401(k) plan either as a regular deferral (pretax) or as a Roth deferral. The character of the deferral as either regular (pre-tax) or Roth may not be subsequently changed. How does a 401(k) plan The plan administrator distinguish administrator is between regular deferrals required to and Roth deferrals? separately account for the Roth deferrals and the regular deferrals. This is to ensure that distributions are correctly reported to the IRS and participants. When must a 401(k) plan Roth deferrals are distribute Roth deferrals subject to the (including earnings)? same required minimum distribution rules that apply to other amounts in a tax-qualified retirement plan. These rules generally require distributions to begin soon after the later of a participant attaining age 70½ or the participant retiring. Also, upon the participant s death, any remaining account balance is subject to death distribution rules that require distributions from the Roth deferral account to occur over a period of years or over the life expectancy of the participant s designated beneficiary, subject to certain rollover rights of beneficiaries. 12

16 May a participant avoid Yes. Rolling over having to commence Roth deferrals (and distributions of Roth earnings) from a deferrals (and earnings) at 401(k) plan to a age 70½ (or if later, after Roth IRA avoids the participant retires)? the application of the required minimum distribution rules (but not the death distribution rules). In other words, for estate planning purposes, distributions from a Roth IRA can be postponed beyond age 70½. May a participant roll over Yes. However, a a distribution from the participant may participant s Roth deferral only roll over a account? distribution of a Roth deferral account to a Roth IRA, or to another qualified plan or 403(b) plan (by a direct rollover) that has Roth deferral provisions and will accept the rollover. If a 60-day rollover is made (rather than a direct rollover), then the entire amount may be rolled over into a Roth IRA, but only the taxable portion of the distribution (i.e., the earnings) may be rolled over to a qualified plan or 403(b) plan. May a participant roll over No. A participant a distribution from a Roth may roll over a IRA into a 401(k) plan? Roth IRA distribution to another Roth IRA, but may not roll over the distribution to a Roth 401(k) plan or a Roth 403(b) plan, even if all of the amounts in the Roth IRA are 13

17 attributable to a roll over contribution from a Roth 401(k) plan or a Roth 403(b) plan. May a retirement plan other Yes. A 403(b) plan than a 401(k) plan have (also known as a Roth accounts? tax-sheltered annuity plan) established by certain educational or charitable organizations also may permit Roth deferrals. The information provided in this pamphlet is based upon complex requirements of the Internal Revenue Code and Treasury Regulations. It is provided with the understanding that the preparer is not engaged in rendering legal, accounting, or other professional services. Although care has been taken to present the material accurately, the preparer disclaims any implied or actual warranties as to the accuracy of any material herein and any liability with respect thereto Roth0106