Some Details on the Roth 401k

Overview of Roth 401k Plan Provisions NORTHWESTERN WISCONSIN ASSOCIATES, INC PENSION CONSULTANTS AND PLAN ADMINISTRATORS Serving Clients Since 1983 Some Details on the Roth 401k Overview of Roth 401k Roth 401k is simply another choice for 401k plans. It allows participants to defer after-tax salary dollars. Contrast this to traditional 401k salary deferrals which have been on a pre-tax basis. Roth 401k is an optional feature that employers can add to a plan, but employers are not required to do so. Roth 401k Basics In very general terms, Roth 401k money is after-tax money. Like a traditional IRA, earnings within the account are not taxed each year. However, Roth 401k money is unique in that qualifying withdrawals are not subject to ordinary incometax. This means that if you follow all of the IRS rules, the money you take out of a Roth 401k at retirement is tax-free. Of course there are tradeoffs and pitfalls, which you should carefully study before choosing. Roth 401k Limits The contribution limits for Roth 401k dollars will be the same as those for traditional 401k contributions. In 2006, the maximum salary deferral limit is $15,000, with an additional $5,000 catch-up provision available to those over age 50. Combining Money-Types Employees may be able to mix how a plan characterizes salary deferrals (if their plan allows it). For example, an employee could say I want 60% of my deducted pay to be Roth 401k money, and the rest to be pre-tax money. Roth 401k Employee vs. Employer Dollars The Roth 401k is only available for employee deferrals. In other words, an employee s salary deferral (or paycheck deduction) can be characterized as Roth-type. However, employer money (matching contributions, profit sharing, and so on) will not be part of Roth 401k. 200511 1

Roth 401k Timeline Plans may begin deferring after-tax dollars starting January 1st 2006. However, it is likely that some plans will not offer the feature at that time. Possible reasons for delay are: At the end of 3rd quarter 2005, the IRS had not issued final regulations and guidance on Roth 401k Plan providers (investment companies) may not be ready to administratively handle Roth 401k accounting Employers may not have fully analyzed the tradeoffs involved in offering Roth 401k There are a variety of other reasons that may hold up the implementation of the Roth feature for a 401k plan. Remember, the employer may offer Roth 401k, but is not required to. In addition, some plans may only offer a portion of what is allowed under Roth 401k rules. The rules say they are allowed to do this, not that they must. Roth 401k Sunset Roth 401k may not be around forever. The laws that allowed Roth 401k were part of EGTRRA, and the rules that allow Roth 401k sunset (or end) in 2011. This means that Congress would need to take action before 2011 for the provisions to become permanent. There is no guarantee that they will do this, so we will have to wait and see. Why Roth 401k Might Not be For You Roth 401k offers the ability to have a different tax status for your money, but there may be some Roth 401k pitfalls. If you follow IRS rules, you can provide tax-free income during retirement. While the promise of tax-free income is important, it is also important to know about Roth 401k drawbacks. Roth 401k Disadvantages If you re excited about the promises of Roth 401k, slow down and make sure that it is right for you. Allow me to play Devil s Advocate and highlight some Roth 401k disadvantages. At this point I ll mention that these may or may not be true disadvantages it really depends on your situation. Everything in life involves tradeoffs, and there s no such thing as a free lunch especially from the IRS. Nevertheless, we do the best we can. 200511 2

Finally, I don t know what your particular situation is. Therefore, this information is strictly for informative purposes. You should, of course, do plenty of research and/or consult with a competent tax advisor before you make any drastic decisions. In no particular order, some potential Roth 401k disadvantages are: It takes more of a bite out of your net pay to place the same number of dollars into the Roth 401k account (because you don t get a current-year tax-deduction). We don t know what tax laws will be in the future. Your tax bracket could be higher or lower who knows? Furthermore, the politicians could just decide that Roth was a bad idea and tax everything. Of course, they would have a hard time getting reelected. The Roth 401k provisions are currently set to sunset (or go away) in 2011. This makes it difficult to assume (for long-term planning purposes) that you ll make Roth-type contributions past 2010. Roth money always has a 5 year rule attached to it as well as age 59.5 to meet the qualified distribution requirements. I won t go into detail on this page, but you should consider whether or not your money will be in a Roth-type account for at least 5 years. To complicate matters, your money may lose its 5+ year aging if you roll it out of a Roth 401k and into a brand new Roth IRA. Roth 401k does not consider a first-time home purchase (as defined by the IRS) as a qualified withdrawal, meaning you may have taxes that you didn t expect if you try to use your Roth 401k dollars for an otherwise qualified first-time home purchase. Non-qualified Roth 401k distributions (in English, that means that the IRS didn t think you had a good reason to take the money) are treated differently than non-qualified Roth IRA distributions. From a Roth IRA, you can generally say you re taking back your original money. Roth 401k may require you to pay taxes on any earnings within your account even if you don t distribute the entire amount. No current-year tax deduction. With traditional 401k contributions you enjoy reduced taxable income in the current year. With Roth 401k, you ll have to wait for any tax benefits. There are a lot of possible Roth 401k disadvantages. The challenges I ve listed above may or may not be significant to you, but they re worth tucking away in the back of your brain. Also, remember that there may be ways for you to manage some of these pitfalls so that they don t affect you. This is not meant to tax or legal advice. We always recommend you consult your tax or legal advisors. 200511 3

What is the difference between a traditional 401(k) and a Roth 401(k)? Traditional 401(k) Roth 401(k) Contributions are Pre-tax After-tax Matching Contributions Allowed Allowed, but matching Contributions are pre-tax 2006 Contribution Limit $15,000 $15,000 $20,000 over age 50 $20,000 if over age 50 Forfeiture Reallocation Yes, if in plan No, treated as E.R. Contribution document Contribution Income Restrictions No No ADP Testing Yes, unless safe harbor Yes, unless safe harbor Investment Earnings Tax-deferred Tax-free Access to Money Yes, subject to plan Yes, subject to plan Provisions provisions Tax-free Distributions Not available Yes, subject to following Conditions: 1) Distribution must be a qualified distribution, attainment of age 591/2, death or being disabled, AND 2) Special 5 year rule. Minimum Distributions Age 701/2 Age 701/2, unless rolled to a Roth IRA Rollovers To a Traditional IRA To a Roth 401(k) or IRA 200511 4

What needs to be done to add the Roth 401(k) Program to a 401(k) Plan 1. The 401(k) plan document will need to be amended to allow Roth contributions. 2. The Summary Plan Description (SPD) must be updated to explain the Roth provisions. 3. The plan sponsors payroll system must be able to track after-tax Roth 401(k) contributions. 4. The timing and frequency of Roth 401(k) elections have to be determined. 5. A participant must irrevocably designate a Roth 401(k) contribution at the time the salary deferral is made. Once made it cannot be changed back to a traditional 401(k). 6. The Roth contributions must be maintained in a separate account apart from all other plan contributions. P.O. Box 907 Wausau, WI 54402-0907 715-848-1929 www.northwesternwisconsin.com Serving Clients Since 1983 200511 5