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Roth 401(K) Provisions
Great
news!
If you sponsor a 401(k) plan, beginning in 2006, you have the option
to take advantage of a new tax-planning feature – the Roth 401(k) Account. The
Roth 401(k) Account is an additional account within your existing 401(k) plan.
As its name suggests, it is intended to mirror many of the benefits of
Roth IRAs. Roth IRAs have been a
tax-planning tool since 1998. Under
a Roth IRA, an individual can make after-tax contributions and receive tax-free
distributions. In addition, minimum
distribution rules (applicable to individuals once they reach age 70½) do not
apply.
You
may ask why Congress created the new Roth 401(k) Account when we already have
Roth IRAs. The answer is that Roth
IRAs are only available for individuals whose adjusted gross income is below a
set dollar limit. Roth 401(k)
Accounts, on the other hand, are available to all participants in the plan,
including high-income wage earners.
The
new Roth 401(k) Account is effective January 1, 2006.
In March 2005, the IRS issued proposed regulations that address some of
the issues associated with Roth 401(k) Accounts.
However, the regulations did not address all issues, so there are still
many unanswered questions, particularly those relating to taxation of
distributions. Even though we are
still waiting for additional guidance from the IRS, we are introducing you to
Roth 401(k) Accounts now, because many of you will choose to add this feature
for 2006 – particularly since the availability of the feature is limited (the
legislation that created the Roth 401(k) Account is currently scheduled to
expire on December 31, 2010).
A.
Designated Roth Contributions
As
mentioned above, Roth 401(k) Accounts are available to all participants.
Beginning with deferrals made after December 31, 2005, a participant can
designate that all or a portion of her/his salary deferrals will be made to a
Roth 401(k) Account. These
deferrals are called "designated Roth contributions" or "DRCs".
Like
Roth IRAs, DRCs are made with after‑tax
dollars. DRCs are immediately
100% vested. Any portion of salary
deferrals that the participant does not designate as DRCs will be pre‑tax
401(k) deferrals. DRCs and pre-tax
401(k) deferrals are aggregated for purposes of the 402(g) limit (see
discussion of this limit on pages 3 and 4).
B.
Qualifying Distributions
If
a distribution of a participant's balance in a Roth 401(k) Account is
"qualified", then investment earnings are tax‑free.
This means that the participant will not pay any income tax (or capital
gains) when she/he withdraws her/his Roth 401(k) Account balance from the plan.
A
distribution must satisfy two requirements in order to be "qualifying"
– (1) the distribution must occur after attainment of age 59½, death or
disability; and (2) the distribution must occur at least 5 years after
the participant contributes her/his first DRC.
For example, if the participant makes her/his first DRC in 2006, then the
first "qualifying" distribution can be made on or after January 1,
2011 (assuming the first requirement is also satisfied).
Qualifying
distributions can be taken in cash or rolled over to an individual Roth IRA or
to a Roth 401(k) Account in another 401(k) plan.
Be aware that participants who roll out their total
account balance under the plan will potentially have to establish two IRAs to
receive the rollover – a traditional IRA for pre-tax 401(k) deferrals and
employer contributions and a Roth IRA for DRCs.
If
a distribution is "non-qualifying", then the investment earnings are
subject to tax. We do not know
exactly how this tax will be determined. The
IRS did not address this in the proposed regulations. They have asked for public
comments and we expect additional guidance from them in the near future.
C.
Administrative Requirements
There
are many additional administrative steps that will be involved in accounting for
DRCs. You should talk to your plan
administrative firm to determine if these additional administrative steps will
result in an increased cost to you.
First,
participants must make a written election to designate their deferrals as DRCs
in advance, before the wages are earned. Normally,
this would be done on the salary reduction agreement form.
Participants can change their election in accordance with the plan's
rules, but once deposited, DRCs must stay in the Roth 401(k) Account.
Second,
a participant's DRCs must be separately accounted for under the plan.
This is a separate "source" account maintained by the plan's
administrative firm and not a separate investment account.
A participant's Roth 401(k) Account must be maintained on the plan's
records until it is fully distributed. No
other contributions or forfeitures can be allocated to the participant's Roth
401(k) Account.
Third,
for those of you who do not have a safe harbor plan, DRCs are subject to
non‑discrimination testing (ADP/ACP).
This testing is already performed on pre-tax 401(k) deferrals under the
plan. Those of you with safe harbor
plans are not subject to this testing.
Finally,
unlike Roth IRAs, DRCs are subject to minimum distribution rules.
This means that the required minimum distributions will have to include
amounts from the participant's Roth 401(k) Account. However, to avoid this
requirement, older participants and beneficiaries can simply roll their Roth
401(k) Account into a Roth IRA.
D.
Steps to Adopt the Roth 401(k) Account
The
first step is to decide whether or not to add the Roth 401(k) Account to your
plan. This
is an elective feature – you are not required to offer it.
If you have any questions about adding the Roth 401(k) Account, we
recommend that you discuss them with your financial advisor.
The
second step is to notify the participants that you have added a new feature to
the plan. For those of you with a
safe harbor plan, this notice will be included in the 2006 Safe Harbor Notice
that will be provided to you by your administrative firm this fall.
A special notice will have to be prepared for non-safe harbor 401(k)
plans.
The
Salary Reduction Agreement (SRA) form for your plan must also be revised so that
participants can elect for their deferrals to be DRCs.
Most likely, this form will be provided with the notice described above.
The SRA form must explain the timing rules that will apply to the
participant's ability to change between DRCs and pre-tax 401(k) deferrals.
In addition, it must state that a participant cannot change the
designation of deferrals that have already been deposited in the plan (i.e., any
change will be prospective only).
Next,
you will need to work with your payroll support company to make sure that they
are prepared to implement a participant's election to make DRCs.
As discussed above, the tax treatment is different for traditional
pre-tax 401(k) deferrals and DRCs. DRCs
can begin with the first payroll on or after January 1, 2006 so we
encourage you to contact your payroll provider now to make sure they will be
ready.
Your
plan document must also be amended. We
do not yet know the deadline, but we expect that an amendment will have to be
adopted by the plan sponsor before the end of the plan year during which DRCs
are first allowed (i.e., December 31, 2006 for calendar year plans).
We anticipate that there will be other required amendments in 2006 for
401(k) plans, so the Roth 401(k) amendment would be done at the same time.
The fee, if any, for the amendment will depend upon the type of plan you
maintain.
AUTOMATIC
ROLLOVERS
Chances
are you have already signed or received an amendment for your plan this year
relating to a new "automatic rollover" requirement (if you have not
already, you will soon!!). This
amendment changes the rules relating to forced distributions of small account
balances.
Previously,
if you had a participant terminate employment and the present value of the
participant's vested benefit under the plan was $5,000
or less, then you could distribute the participant's benefit in cash, even
without the participant's consent. Effective
with respect to distributions after March 28, 2005, Congress changed the rules.
Under
the new rules, if you have a participant terminate employment and the present
value of the participant's vested benefit under the plan is not
less than $1,000 and not greater than $5,000, you now have to roll over the
participant's benefit to an IRA, unless the participant affirmatively
elects to take cash. For
benefits under $1,000, you can still distribute the benefit in cash.
To
comply with these new "automatic rollover" rules, you must locate a
qualified IRA provider to accept the automatic rollover accounts.
Your plan administrative firm or financial advisor can assist you in
locating such a provider. Contact
them for assistance.
In
lieu of implementing the new "automatic rollover" rules, some plan
administrative firms have recommended that the plan be amended to provide that
only benefits of $1,000 or less can be forced out.
The advantage of this approach is that you do not have to worry about the
additional administrative burden associated with establishing IRAs for your
participants. The disadvantage is
that you cannot make any distributions of benefits greater than $1,000 without
the participant's consent.
If
you have any questions about this, please contact your financial advisor, plan
administrative firm or us.
Rehired Employees
In
virtually all plans, if you rehire an employee who previously worked for your
business (or a predecessor or related business), her/his prior employment is
counted in determining her/his eligibility for the plan.
This applies even if the prior
employment occurred before the plan existed.
Normally, a rehired employee who had met the eligibility requirements
previously, is eligible immediately as
of her/his date of re-employment.
The
following two examples of plans with 12 month/1000 hour eligibility illustrate
this. Assume that employee Jane
worked for your business from 1985 through 1988 (and had over 1000 hours in a 12
month period). You established a
retirement plan in 2003. If you
rehire her on September 1, 2005, she is eligible to participate in the plan
immediately on September 1, 2005, her date of rehire.
Employee Nicole was hired April 1, 2000 and worked until December of
2000. When she quit, she had worked
over 1000 hours. If she is rehired
on May 1, 2005, she is eligible to participate in the plan immediately on May 1,
2005, her date of rehire. This is
because more than 12 months has passed since her original hire date and she
worked more than 1000 hours before she quit in 2000.
Note
that the rehire rules apply even if the employee is coming back to work on an
intermittent, temporary or part-time basis.
If a rehired employee is eligible and you have a safe harbor 401(k) plan,
you must give her the
SAFE HARBOR NOTICE FOR 401(K) PLANS
The
Safe Harbor Notice is the key document in the annual operation of a safe harbor
401(k) plan. The notice describes
in simple terms the major provisions of the plan.
A
new participant must be given the Safe Harbor Notice (and preferably also
the Summary Plan Description and Salary Reduction Agreement form) 30 to 90 days
before her/his plan entry date. Check
your Summary Plan Description to identify the entry dates for your plan.
For most plans, the plan entry dates are the first day of the plan year
and the first day of the 7th month of the plan year on
or after the date the employee completes the eligibility requirements.
For calendar year plans, those
entry dates are January 1 and July 1. So,
if a new participant will enter the plan on July 1, 2006, you must give her/him
the Safe Harbor Notice sometime between April 2 and June 1 of 2006.
In addition to providing the initial notice, a
A participant must have at least 30 days at some time after receiving the Safe Harbor Notice to make or modify her/his salary reduction agreement. In addition, changes to the salary reduction agreement can be made as of the dates set out in the salary reduction agreement form.
CONSEQUENCES TO GIVE NOTICE TIMELY
f
you do not give an eligible employee (including a rehired employee) the Safe
Harbor Notice timely and allow salary deferrals to be made, you have caused, at
the very least, an operational error which should be corrected under the IRS
program known as Employee Plans Compliance Resolution System (EPCRS).
This will result in increased funding costs and administrative and legal
expenses to you.
401(k)
SALARY DEFERRAL LIMITS
The dollar limits for making salary deferrals to 401(k) plans (called the 402(g) limit) and the new "catch-up" rules continue to increase. The catch-up rules can allow plan participants who are 50 or older at any time during the year to make additional "catch‑up" salary deferrals. The limits through 2006 are listed below. After 2006 the limits are indexed for inflation.
Additional
Calendar
year
402(g) limit Catch-up
limit
2005
$14,000
$4,000
2006
$15,000
$5,000
PLAN
LOANS TO PARTICIPANTS
Some
plans allow loans to be made to participants.
Loans must comply with a number of precise rules and restrictions,
including a specific repayment schedule. Repayment
of the loan must begin within 90 days of the date it is made, according to the
repayment schedule. The trustee of
the plan is responsible for collecting the payments on a timely basis.
If any of the loan restrictions are violated, or if
repayments are not timely, the entire loan could be treated as a taxable
distribution to the borrower participant. This
means that it will be reported as current taxable income.
An additional 10% penalty tax may also be assessed.
In addition, the loan may still have to be repaid.
Because of the complexities
and serious consequences of improper loans, contact your plan administrative
firm to prepare the documentation for any loans from the plan and strictly
adhere to the repayment schedule.
IRS
AUDITS
The
IRS is currently auditing defined benefit plans and 401(k) plans.
If the IRS contacts you about an
audit, contact us immediately.
IRAs AND ROLLOVERS
A
qualified plan may accept rollovers from a traditional IRA; from IRAs that have
been commingled with distributions from qualified plans; from distributions from
403(b) plans; or from certain governmental 457 plans.
Generally, Roth IRAs and other IRAs containing any
after-tax contributions may not be rolled into a qualified plan.
Before you make or allow any
rollovers, contact your financial advisor or us.
The
assets of your 401(k) plan include the amounts that participants have requested
your business withhold from their wages to defer into the plan.
Labor Department regulations state that participant
401(k) salary deferrals (including the new DRCs, if applicable) must be
transmitted (i.e., deposited into
or a check mailed) to the plan trust account as of the earliest
date on which it is reasonably possible to do so.
We continue to recommend that you transmit participant 401(k) salary
deferrals as soon as practical after
they are withheld from the participants' paychecks, but in no event later than 7
days after they are withheld.
Please give your financial
advisor, plan administrative firm or us a call if you have any questions.
In
the past, many of you have been able to apply your pre-funded employer
contributions to "cover" any late deposits of 401(k) salary
deferral amounts. Effective in
2006, the IRS will no longer allow this practice.
Thus, it is more important than ever that you get each deposit into the
plan on a timely basis.
Any
change in your business structure (incorporation, new partner, split in
partnership, etc.) may impact your qualified retirement plan.
Please let us know about any
change in your business structure as soon as possible.
Also, please notify us of any changes regarding your office, mailing or
email address or your telephone or fax number (including area code) so that we
may keep our records up to date.
EGTRRA
PLAN RESTATEMENT
Over
the past decade, Congress has been very busy making changes to retirement plan
rules. All of these changes must be
incorporated in your plan documents.
Your
plans have already been amended for many of these changes – including the GUST
restatement in 2001/2002, the EGTRRA good faith amendment in 2002, the final
401(a)(9) regulations for defined contribution plans (Post-EGTRRA amendment) in
2003 and now the automatic rollover amendment in 2005.
These have all been legally
required amendments.
We
understand that keeping up with these changes can seem exasperating at times.
So, we thought we would take just a minute to prepare you for what is
ahead. We anticipate that there
will be another required amendment for most plans next year (the Roth 401(k)
provisions would be included, if applicable).
Sometime between 2007 and 2010, all
qualified plans will have to be completely restated to incorporate all the
changes from the 2001 EGTRRA legislation and several post-EGTRRA laws and
regulations.
We
are certainly aware of the costs involved with all of these changes.
We remain committed to providing high-quality, cost-effective service.
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