The Roth 401(k) and Financial Planning Strategies
Increased Eligibility and Flexibility for Different Taxpayer Needs

By Leonard J. Lauricella

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IRAs have existed since 1974. Much attention has recently been directed toward Roth IRAs, which have been available since 1998. With a Roth IRA, the money goes in on an after-tax basis; as long as certain requirements are met, both earnings and contributions are distributed free of tax.

When Congress enacted the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), the act added IRC section 402A. The addition provided for a new vehicle, the Roth 401(k), with an effective date of January 1, 2006. At the outset, two potential issues may prevent many taxpayers from being able to participate in a Roth 401(k). As stated in IRC section 402A(b)(2), a section 401(k) plan providing for a Roth election must provide separate accounts for each participant’s Roth contributions. Additionally, the plan must maintain separate recordkeeping with respect to each account. This requires amending plans and systems, and employers will incur extra costs and complexity. Also, EGTRRA section 901, which deals with Roth 401(k)s, will sunset after December 31, 2010, unless future legislation provides otherwise. The decision of whether to participate is complicated by other factors, including the decreased cash flow resulting from the loss of tax deferral on the contribution.

Roth IRAs

Roth IRAs came into the law with the Taxpayer Relief Act of 1997 [P.L. 105-34, section 302(a), (111 Stat. 788)]. Under the previous IRA rules [IRC section 219(b)(5)], taxpayers not covered by qualified retirement plans and those with adjusted gross income (AGI) below certain limits could make tax-deductible contributions to an IRA up to an annual limit ($4,000 for 2006, and $5,000 for employees over age 50). All distributions from the regular IRA were taxable upon receipt. Under IRC section 408(o)(2), taxpayers not making deductible contributions could make nondeductible contributions of up to the same limits regardless of their level of AGI or whether they were participants in a qualified plan. It was also possible to make both deductible and nondeductible contributions, but the total contributions could not exceed the single annual limit. A taxpayer who made nondeductible contributions to an IRA received an adjusted basis in the IRA equal to the total amount. Distributions would then be partially from taxable income and partially a return of basis. In all other cases, distributions were fully taxable.

The Roth IRA offered a new alternative by permitting nondeductible contributions up to the same limits as other IRAs, along with qualified distributions that would be completely free of tax [see sections 408A(c)(2) and (d)(1)]. A qualified distribution had to occur after a period of five tax years and be a result of the taxpayer’s attaining age 59 Qs , the death or disability of the taxpayer, or qualifying first-time-homebuyer expenses. The five-year period begins on the first day of the tax year for which the taxpayer made a regular contribution to any Roth IRA. The full contribution limit for the Roth IRA, however, is available only to taxpayers with an AGI below $150,000 for joint filers, below $95,000 for single taxpayers, and zero for married taxpayers filing separately. The annual contribution limit phases out completely at AGI of $160,000, $110,000, and zero, respectively. [See section 408A(c)(3)(A). Married taxpayers filing separately and living apart were exempted from the zero-AGI limitation by section 408A(c)(3)(D).] Therefore, the non-Roth nondeductible IRA was retained for taxpayers unable to take advantage of the Roth IRA due to the AGI limitation.

The Roth IRA legislation contained many favorable provisions. In addition to the tax-free distribution of earnings, a Roth IRA, unlike a regular IRA, has no minimum distribution requirement during the beneficiary’s lifetime. [See IRC section 408A(c)(5).] Taxpayers reaching age 70 Qs who do not otherwise need cash can allow the funds to continue to grow on a tax-free basis, and if they have earned income and meet the requirements discussed above they can continue to contribute to their Roth IRAs. Taxpayers with regular IRAs cannot make contributions after reaching age 70 Qs . [See IRC sections 219(d) and 408A(c)(4).] The IRC also permits tax-free rollovers from one Roth IRA to another, and taxpayers with regular IRAs and AGI below $100,000 can convert a regular IRA to a Roth IRA by including in income the fair market value of the regular IRA on the conversion date. For this purpose, the AGI limit is now computed without including the regular IRA distribution; this conversion contribution does not affect the annual contribution limit. This provision could be helpful to taxpayers who, for example, might otherwise be subject to the alternative minimum tax (AMT) and therefore wish to accelerate income into the current year. Nonqualified distributions of income from a Roth IRA are included in gross income, and just like a regular IRA, it may be subject to a 10% penalty. A favorable ordering rule provides that distributions from a Roth IRA come first from contributions that were already included in income because the Roth contributions are nondeductible [section 408A(d)(4)(B)], so earnings from the Roth IRA are not considered distributed until all contributions have been recovered.

Traditional 401(k) Plans

The benefits of participation in a 401(k) plan differ in certain key respects from those of an IRA. While 401(k) contributions are made on a pretax basis and the earnings are allowed to grow tax-deferred, all distributions are taxable. Minimum distributions must begin by April 1 of the calendar year following attaining age 70 Qs or retirement, whichever is later [section 401(a)(9)]. A direct rollover or a conversion to a Roth IRA is not permitted from a qualified plan, including a 401(k), but a rollover to a regular IRA is permitted on a tax-free basis, and assuming the normal conversion requirements are met, this IRA could then presumably be converted to a Roth IRA in a similar manner to a regular IRA conversion. But distributions (including rollovers) from a 401(k) can generally only occur upon a specific event, such as the employee’s retirement, separation from service, disability, or death [section 401(k)(2)(B)(i)].

Nevertheless, the 401(k) has major advantages over the Roth IRA. The 401(k) does not have an AGI limit for making contributions. This avoids the problem faced by taxpayers who make Roth contributions during the year only to find out that some unexpected income at the end of the year renders them ineligible for the Roth IRA. These taxpayers then end up having to include the earnings from the Roth in income for the year. [See Treasury Regulations section 1.408A-6, Q & A 1(d).] In addition, the amount that a taxpayer can contribute to a 401(k) is significantly higher than the Roth IRA limit [$15,000 for 2006, and $20,000 for employees over age 50; see section 402(g)(1)], and, as mentioned above, some employers match some or all of an employee’s 401(k) contribution. Of course, because the 401(k) contribution reduces AGI and taxable income, several collateral benefits may apply. For example, this may enable the taxpayer to deduct a loss from active participation in rental real estate that might otherwise have been limited by the passive-activity-loss rules of IRC section 469. This also may increase the use of itemized deductions that are limited by a percentage of AGI. [See sections 68(a) and 151(d)(3). These benefit-reduction sections are scheduled to begin phasing out in 2006, as provided in IRC sections 68(f)(1) and 151(d)(3)(E).]

Roth 401(k)

The Roth 401(k) combines advantages of both plans. Unlike for the Roth IRA, there is no AGI limit for contributions, and the Roth 401(k) is treated as a regular cash or deferred arrangement. There is immediate vesting, and the section 402 limitations apply to contributions. Participants in plans offering the Roth 401 option will then be able to choose between the deductible 401(k) and the nondeductible Roth 401(k), or perhaps split the contributions between the two. Employees receiving matching contributions would have to use both types, because the employer match can be deposited only into the regular 401(k) plan.

A Roth 401(k) must be an applicable retirement plan. This includes a section 401(a) employee trust exempt from tax under section 501(a), and a section 403(b) plan. [See sections 402A(a) and (e)(1).] The applicable retirement plan must include a qualified Roth contribution program subject to the nondiscrimination tests. In addition, an employee must be able to elect to make designated Roth contributions in lieu of some or all of the elective deferrals otherwise eligible under the applicable retirement plan [sections 402A(a) and (b)(1)]. Such designated Roth contributions are then treated as elective deferrals, except that the employee has to include the contributions in income [section 402A(a)(1)]. In addition, the employee must irrevocably designate that the contributions are not excluded at the time of the election, and the employer must treat the contributions as includible in the employee’s income by treating the contributions as subject to withholding [Treasury Regulations section 1.401(k)-1(f)(1)]. The designated contribution must be held in a separate account maintained for the employee, with a separate record of the employee’s undistributed contributions. Gains and losses must be separately allocated on a reasonable basis between the Roth contribution account and other accounts under the plan, and the separate accounting must begin at the time of the first contribution and continue until the designated Roth contribution account is completely distributed.

Any excess contributions made to a Roth 401(k) contribution account can be withdrawn and the contributions not included in income as long as the distribution is no later than April 15 of the year following the contributions. Any distributions of excess contributions after that date will be included in income, notwithstanding that the contribution was nondeductible [sections 402(g)(2) and 402A(d)(3)]. Income attributable to the excess contributions must also be distributed, and it is treated similar to income on excess contributions distributed from a regular 401(k) plan [see section 402A(d)(3) and Treasury Regulations section 1.401(k)-2(b)(2)(vi)(C)].

As indicated, any qualified distribution from a designated Roth account is excludible from gross income [section 402A(d)(1)]. “Qualified distribution” is defined similar to the Roth IRA rules, except that distributions for first-time homebuyer expenses are not included [section 402A(d)(2)(A) incorporating section 408A(d)(2)(A) without clause (iv)]. Therefore, a distribution must be made on or after attaining age 59 Qs , or as a result of death or disability. Even if the above requirements are met, however, a distribution from a Roth 401(k) will not be excludible if it is made within a five-year period. This period begins with the earlier of the first tax year a designated Roth contribution was made to an account under the plan, or, if a rollover contribution was made to the plan, the first tax year a designated Roth contribution was made to the account that was rolled over [section 402A(d)(2)(B)].

Rollover distributions from a Roth 401(k) may be made only to other Roth accounts. Roth 401(k)s and Roth IRAs can be rolled over to a similar account; Roth 401(k)s may be rolled into Roth IRAs, but not vice versa, and rollovers between Roth and non-Roth accounts, including qualified plans, are not permitted on a tax-free basis [section 402A(c)(3)(A)].

Choices Galore

While most taxpayers will undoubtedly be happy to have the choice to contribute to a Roth 401(k), the planning becomes significantly more complex. A complete analysis is beyond the scope of this article, but the following thoughts are offered.

For taxpayers already contributing to a 401(k) plan, the first decision may be whether to continue with the tax-deductible 401(k) contributions or to switch to the nondeductible, but tax-free on distribution, Roth 401(k). For younger employees in lower tax brackets, the benefits of the tax deduction may be outweighed by the benefit of long-term tax-free compounding. As taxpayers get older and move into higher tax brackets, the choice becomes more problematic and will no doubt require significant analysis. Factor on top of this the many potential unknowns of near-term tax reform, and one can easily see that a high premium is placed on the ability to make decisions under extremely uncertain conditions.

401(k) education fund. Further complicating the above decision is the ability of the new higher-limit Roth 401(k) plans to replace or supplement other tax-deferred or tax-exempt plans. A taxpayer who has enough money may consider fully funding some or all of these plans, but most people will have to make difficult choices in certain areas, such as education planning.

For example, an older employee-grandparent might lean toward the deductible 401(k), but if contributions are made to a Roth 401(k) that is then rolled into a Roth IRA, significant savings can be accumulated to be used for a college funding gift. At the same time, the owner gets more control over the investments and at least as good if not better tax consequences on distribution than would be possible with, for example, a section 529 plan, where the investment options may be limited and a noneducation distribution would be taxable [section 529(c)(3)(A)]. The Roth funds can be used for anyone, not just a family member, and because the Roth money can be distributed tax-free and then contributed by the owner directly to the higher education institution, the transfer would qualify for the unlimited gift tax exclusion [section 2503(e)], unlike contributions to section 529 plans [section 529(c)(2)(A)(ii)]. The Roth plans also give the owner more control over the ultimate disposition of the funds than, for example, a Uniform Transfer to Minors Act account, where, upon reaching majority, the recipient can use the funds for any purpose.

Compared with a Coverdell IRA, the Roth seems a superior choice. The maximum annual contribution to a Coverdell is only $2,000, the contribution is nondeductible, contributions have an AGI limit, and generally no contributions are allowed after the beneficiary reaches age 18. Distributions are generally taxable and subject to a 10% excise tax unless they are used for education. In addition, distributions must be made to family members before they reach age 30 [section 530(b)(1)(E)], and may, under certain circumstances, force a choice between excluding the distributions from income or taking the benefits of the education credits. Roth plans have none of these limitations and are far more flexible.

401(k) healthcare fund. Another fruitful use for built-up tax-free funds might be healthcare. Many employers offer the ability to put pretax funds into a flexible spending arrangement (FSA). While participation in these plans can be useful, employer-imposed limits on the amount of contributions are generally far below 401(k) contribution limits. Once an employee specifies how much will be contributed during the year, the amount generally may not be changed for that year, absent a change in circumstances (such as marriage, birth of a child). Finally, any balance in the plan not used for reimbursement of medical costs inured prior to the period ending no later than two and one-half months after the close of the year for which contributions were made to the FSA is forfeited to the employer. Except for the lack of a tax deduction, the Roth appears to offer superior results. Younger employees who tend to have fewer medical expenses and to be in a lower tax bracket may especially want to cut back on FSA contributions in favor of a Roth. As the employee gets older, some new contributions could be switched from the Roth to the FSA, but by then the employee should be enjoying the benefits of the earlier tax-free compounding. Of course, for any year where the employee expects significant-out-of pocket medical expenses (braces, birth of a child, elective surgery), the FSA/Roth contributions could be adjusted in advance.

Comparing a Roth 401(k) with the new health savings accounts (HSA) is more complex. These plans allow tax-deductible contributions, tax-free compounding, and tax-free distributions. Again, the limit on contributions is far below the 401(k) limit, and in order to contribute to an HSA an individual must have a high-deductible health insurance plan. The deductibles must be at least $1,000 for single individuals and $2,000 for families [section 223(c)(2)(A)]. Distributions generally must be used for qualified medical expenses. If a taxpayer is otherwise inclined to go with a high-deductible medical insurance plan, the above-the-line tax deduction may favor the HSA, because there is no time limit on when the expenses can be reimbursed.

Thus a taxpayer incurring a reimbursable medical expense in 2006 may allow the money to grow tax free in the HSA and withdraw the money at a later date when the funds are needed, regardless of what the funds are used for, because technically they are a reimbursement of past medical expenses. One problem will be to fine-tune the amount allowed to compound in the HSA so as to leave enough to cover the expected medical expenses, but not so much that taxable distributions will eventually have to be taken out. Any amounts left at the time of death of the beneficiary will have to be taken into income unless the account is inherited by the beneficiary’s spouse [section 223(f)(8)]. The Roth avoids the necessity of the high-deductible health insurance, the possibility that some of the funds may be taxable, and the administrative complexity of having to keep track of several plans. Perhaps an even better idea might be to use the two plans in tandem. The tax savings from the deductible HSA could be used to fund the Roth IRA. Medical expense reimbursements could then be withdrawn first from the HSA to avoid the problem of the excess build-up.

Concern over Access to Funds

Taxpayers might be concerned that, given the restrictions on when money can be withdrawn without penalty from a 401(k) plan, investing in a Roth 401(k) may lock up funds for a long time. This may have been a valid concern when most people stayed at a single employer for their entire career. Now, however, every time an employee changes jobs the Roth 401(k) can be rolled into a Roth IRA. If the five-year holding period for the IRA has already been met, any amounts contributed to the Roth 401(k) can be immediately withdrawn without tax. Unfortunately, if the Roth IRA was set up to receive the rollover, the five-year period will start again, even if the employee had been contributing to the Roth 401(k) for more than five years. [Proposed Treasury Regulation section 1.408A-10 Q&A 4, 1/26/2006]. (For this reason, and to obtain the benefit of early contributions to tax-free compounding, a premium is placed on establishing a Roth IRA as soon as an employee is eligible).

Planning is still possible even if the five-year period has to start over. For example, if the taxpayer can take out a tax-deductible home equity loan, favorable tax arbitrage may result. An investment in taxable fixed income securities inside a Roth vehicle will be treated for tax purposes like an investment in municipal bonds (without the private-activity AMT worry), but the return on the investment will be at the higher taxable security rate. This might be used as part or all of the otherwise more highly taxed fixed income portion of a diversified portfolio. There is of course no requirement that the entire balance in a Roth 401(k) must be rolled into an IRA. Under the proposed regulations, the first money rolled from a Roth 401(k) into a Roth IRA is the part of the distribution that would otherwise be taxable. So the taxpayer could roll the earnings from the Roth 401(k) into the IRA and keep the post-tax contributions without incurring tax [Proposed Treasury Regulation section 1.402A-1(d), 1/26/2006].

Employees less than five years from retirement must be aware of the Proposed Regulation under section 408A when deciding whether to contribute to a Roth 401(k). For example, an employee with four years to retirement who does not have an already five-year-aged Roth IRA might have to wait nine years from the time of the initial contribution to get completely tax-free distributions.

What Is Better for the Beneficiary?

From the perspective of successor beneficiaries, the Roth IRA would clearly be superior to the regular IRA. It is possible that the estate tax will be permanently repealed, but assuming it remains in some form, both IRAs are likely to be included in the estate of the decedent. Distributions from the Roth would be tax-free, while distributions from the regular IRA would be taxable as income in respect of a decedent, which might be lessened by the IRC section 691(c) deduction for a portion of the estate tax.

The distribution rules for beneficiaries after the death of the IRA owner are exceedingly complex, but some points bear mentioning. If the beneficiary of a Roth IRA is a spouse, the spouse can become the owner and make the IRA her own. In that case, no minimum required distributions are required during the lifetime of the inheriting spouse, and the tax-free compounding can continue. The beneficiary inheriting from the spouse could then stretch out the distributions over his life expectancy. A spouse inheriting a regular IRA may also make the IRA her own, but distributions generally must begin no later than upon reaching age 70 Qs . For nonspouse beneficiaries, the distribution rules are generally the same, except that the Roth beneficiary is receiving tax-free income. Because taxpayers who are likely to be the biggest beneficiaries of spreading out the tax-free build-up are also more likely to have a high AGI, the Roth 401(k) may be the only way they can end up with a Roth IRA.

Taxpayers with regular IRAs could attempt to convert them to Roth IRAs, presuming they meet the AGI requirements, if after analysis it makes sense to pay the tax up-front. Alternatively, if they were otherwise so inclined, they could keep the regular IRA and use it to fund charitable contributions from their estate.

The Roth 401(k) appears to offer many exciting planning possibilities for those willing to tackle the complexities involved.