Guidance expected on Roth rules

Federal regulators soon will issue eagerly sought guidance to aid employers that want to amend their 401(k) plans to allow participants to roll over account balances into a Roth 401(k) plan.

That rollover feature was included in a small-business jobs bill that Congress passed in September and President Barack Obama signed into law. If employers add the conversion feature this year, employees who roll over funds into a Roth 401(k) will get an extra tax break.

Under the law, employees who roll over funds from their regular 401(k) plan to a Roth 401(k) account by the end of this year can pay taxes that are due on the money in equal parts in 2011 and 2012, rather than pay the entire tax liability next year.

But employers have been reluctant to add the feature until regulators resolve numerous questions that have arisen since the legislation passed.

“Guidance is very much needed,” said Valerie Kupferschmidt, senior counsel with Aon Hewitt Inc.

Questions include whether the rollover funds are subject to a 20% withholding tax on certain pension distributions, and whether the money must be segregated from funds already in employees’ Roth 401(k) accounts.

“We have numerous issues” for which guidance is necessary, said Larry Goldbrum, general counsel for the Spark Institute, which represents retirement plan service providers and investment managers.

Treasury Department officials said that they are aware of the need for guidance and that they are moving quickly to provide it.

“It is something we are working on as quickly as we can. It is on a fast track,” said J. Mark Iwry, deputy assistant secretary for retirement and health policy at the Treasury Department.

Contributions to Roth 401(k) accounts are taxed differently from contributions to traditional 401(k) plans. In a traditional 401(k), employees make pretax contributions.

Those contributions, as well as employer matching contributions and investment income, are taxed when the participant receives a distribution, such as at retirement.

In a Roth 401(k), contributions are made with after-tax money. Contributions and any investment income earned aren’t taxed when the participant receives a distribution, if certain conditions are met.

Under the recent legislation, participants who rolled over funds from a regular 401(k) to a Roth 401(k) account would be taxed on the funds that were rolled over, which then would earn tax-free investment income and be exempt from taxes when distributed to participants.

Depending on participants’ current and future tax brackets, rolling over funds could reduce tax liability. For example, if tax rates increase, participants who rolled over funds from a 401(k) plan to a Roth 401(k) and paid taxes now on the transferred amount would pay less in taxes than if they kept the money in a regular 401(k) plan and took a distribution later.

“First we had Investment Education 101, which was about the importance of diversifying investments. This is Investing 102, which is about tax liability diversification,” said Marina Edwards, a senior consultant with Towers Watson & Co., referring to investing in a Roth account.

“It is a way of hedging your bets” by having funds in traditional and Roth 401(k) accounts, said Bill McClain, a principal of Mercer LLC.

To offer the option, employers must have or add a Roth feature in their 401(k) plans. A survey last year by Hewitt Associates Inc. (now known as Aon Hewitt after its acquisition by Aon Corp.) found that 29% of respondents already offered a Roth 401(k) option, while one-quarter said that they were either likely or somewhat likely to add the feature this year.

Jerry Geisel is a reporter at sister publication Business Insurance.

Related Topics: 401(k) plans