Spring, 2006 Edition

• Roth 401(k)
• Bankruptcy Protection for IRA Accounts
• New Law Puts Long-Term Care Insurance Into Focus
• IRS Announces Cost of Living Increases
• Disability Overhead Expense: An Overlooked, But Valuable Coverage

 

Roth 401(k)

Beginning in 2006, 401(k) Plans are allowed to add provisions allowing for Roth 401(k) contributions by participants. The Roth 401(k) has attracted a lot of attention and while there are advantages for some participants, there are also a number of costs and administrative issues that should be considered.

What is the difference between a regular 401(k) and Roth 401(k)?

With a traditional 401(k) Plan, contributions are made on a pre-tax basis and contributions reduce taxable income each year, providing a current tax incentive. When the contributions and earnings are withdrawn, the account is subject to income taxes. The Roth 401(k) involves making a 401(k) contribution on an after-tax basis. It is similar to the popular Roth IRA in that in exchange for foregoing an up-front tax advantage, the contribution and earnings can be withdrawn in the future on a tax-free basis.

In order to qualify for tax-free status, withdrawals from the Roth 401(k) account must be considered "qualified," which consists of two requirements. The first is a "5-year rule": A participant must wait five years from the start of making Roth 401(k) contributions to qualify for tax-free withdrawal. Oddly, this doesn't apply to each year's contributions, only the commencement of Roth 401(k) contributions. Thus, for anyone making Roth 401(k) contributions in 2006, the date to remember is January 1, 2011. Second, the distribution must be for a "qualified purpose," meaning that the participant must reach age 59 1/2, become disabled or die.

How does a Roth 401(k) impact contribution limits, testing and Matching?

The limits for traditional 401(k) contributions also apply to Roth 401(k) contributions. Thus, for 2006, the maximum allowable contribution would be $15,000. The Catch-Up contribution rules also apply, so for those age 50 or over, the limit is $20,000. While Plans may allow for a combination of both traditional 401(k) and Roth 401(k) contributions, the overall limits above will still cap the overall contribution for each participant.

Roth 401(k) contributions are treated the same way as traditional 401(k) contributions for purposes of non-discrimination testing.

While Roth 401(k) contributions are eligible for employer Matching contributions, the Matching account will still be on the traditional tax-deferred basis. In other words, Matching contributions attributable to Roth 401(k) contributions cannot be withdrawn tax-free at retirement.

Who benefits from a Roth 401(k)?

Whether making Roth 401(k) contributions or traditional 401(k) contributions is best truly comes down to the circumstances and future expectations for each individual. In general, those who are currently in a low tax bracket and expect that when funds are withdrawn, they will be in a higher tax bracket, would benefit from making Roth 401(k) contributions. We recommend that participants analyze their own tax situation with their investment advisors.

What administrative issues/potential costs are involved?

Employers adding the Roth 401(k) option will have to make sure that their payroll providers or internal payroll system can handle the withholding and reporting differences. We still see situations where payroll companies do not handle Catch-Up contributions correctly, so it's not a foregone conclusion that the Roth 401(k) will be handled right.

As with any plan change, adding the Roth 401(k) provisions will require the Plan to be amended. Additional information will also have to be provided to participants informing them of the change.

Because of the tax treatment differences, Roth 401(k) contributions must be accounted for separately from other accounts. Additional records must also be kept of the cumulative total of Roth 401(k) contributions. Upon withdrawal, separate 1099-R forms may be required to differentiate between the Roth 401(k) and non-Roth portions of a participant's account.

Could the government take it all away?

Yes.

In fact, unless Congress acts, the Roth 401(k) will end on January 1, 2011. The Roth 401(k) was part of the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), which unless extended, will "sunset" after 2010. If this occurs, it is possible that the favorable tax treatment for Roth 401(k) would be eliminated. Given the potential political uproar, it's unlikely that would happen. But if allowed to sunset, Roth 401(k) contributions would no longer be allowed to be made starting in 2011, making it a short-lived benefit.

Another government issue concerns future tax rates. Current rates are low by historical standards and many believe that when confronting growing deficits, the government will raise income tax rates. This would, of course, increase the value of making Roth 401(k) contributions now and avoiding the tax hit later. It's also possible, however, that Congress in the future could decide to tax all or some portion of the earnings in the Roth 401(k) accounts, eroding the benefits. Further, if a complete overhaul of the tax system occurs and, let's say, a consumption tax is imposed and the income tax eliminated, then the Roth 401(k) would seriously be a bad deal.

In conclusion, the Roth 401(k) does offer potential benefits for certain participants, but must be weighed against administrative complexities and costs involved. Please contact us should you be interested in further information regarding Roth 401(k)'s.

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Bankruptcy Protection for IRA Accounts

Federal bankruptcy law has offered full protection from creditors' claims to assets accumulated under tax-qualified retirement plans, such as Pension Plans, Profit Sharing Plans, and 401(k)s. Protection for IRA's was not provided to the same extent by federal law and thus had always depended upon the laws of the various states, which differ to a large degree: some provide complete protection from creditors of IRA assets and others provide none, with many falling somewhere in between.

Two separate developments during 2005 have dramatically changed the protection of IRA assets in many situations. The United States Supreme Court's Rousey v. Jacoway decision held that IRA's are provided bankruptcy protection under federal law. However, since the Rousey holding interpreted only federal bankruptcy law, it does not apply to state bankruptcy laws. In most states, individuals filing bankruptcy may not use the exemptions available under federal law - they are subject to those provided by state law.

Shortly after the Rousey decision was handed down, Congress enacted the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA). This law, effective for bankruptcies filed on or after October 17, 2005, significantly changed the treatment of Retirement Plan benefits under the Federal Bankruptcy Code.

The primary attention given to the BAPCPA focused on its provisions which make it more difficult to file for bankruptcy relief. However, it also included provisions which grant Retirement Plan assets significantly greater protection than under previous federal law. Specifically, the new law exempts from the bankruptcy estate assets in the following Retirement Plans: Pension, Profit Sharing, and 401(k); tax-sheltered annuities; IRA's (including SEP's, SIMPLE's, and Roth); and government and church plans.

Notably, the exemption is unlimited except in the case of "traditional" contributory IRA's and Roth IRA's, which are subject to an aggregate limit of $1,000,000 per individual. This limit does not apply to rollovers (funds transferred directly from one of the other types of plans mentioned), nor does it apply to SEP's or SIMPLE IRA's.

Thus, 2005 represented a year in which considerable progress was made in the extension of bankruptcy protection to IRA assets. It is important to note that there are still limits on this protection. Further, state law continues to control many issues regarding non-bankruptcy creditor protection. In such a situation, assets under a Pension, Profit Sharing, or 401(k) Plan are protected, while protection of IRA's remains uncertain.

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New Law Puts Long-Term Care Insurance Into Focus

The Deficit Reduction Act of 2005 was signed into law on February 8, 2006. One of its major provisions will greatly reduce the availability of asset transfers by wealthy individuals, as a means of qualifying for Medicaid nursing home coverage.

Specifically, the law increases the "look-back period" under Medicaid's transfer of assets rule from three to five years. Further, it makes ineligible for Medicaid nursing home coverage any individual with home equity in excess of $500,000. Finally, it changes the date the penalty period for asset transfers commences from the actual date of the transfer to the date the individual becomes eligible for Medicaid.

The overall impact of these new rules is to make asset transfers aimed at qualifying for Medicaid nursing home coverage far more difficult. It thus greatly increases the importance of carrying Long-Term Care Insurance coverage.

Another important provision of the same law provides for the expansion of the "Partnership for Long-Term Care" beyond the few states where it is currently available (California, Connecticut, Illinois, Indiana, and New York). This "Partnership" allows an individual to purchase an eligible Long-Term Care Insurance policy, and automatically qualify for Medicaid nursing home coverage once the policy benefits have been exhausted - without the normal requirement of spending down all assets. While it may take some time before additional states are involved in the "Partnership for Long-Term Care," its potential expansion is a very positive development.

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IRS Announces Cost of Living Increases

	2005	2006
Taxable Wage Base	$90,000	$94,200
Includable Compensation Limit	$210,000	$220,000
401(k)/403(b) Deferral Limit	$14,000	$15,000
401(k)/403(b), 457 Catch-up Limit	$4,000	$5,000
Defined Contribution 415 Limit	$42,000	$44,000
Defined Benefit 415 Limit	$170,000	$175,000
SIMPLE Deferral Limit	$10,000	$10,000
SIMPLE 401(k) & IRA Catch-up Limit	$2,000	$2,500
Highly Compensated Employee	$95,000	$100,000
SEP Compensation Limit	$450	$450
457 Deferral Limit	$14,000	$15,000

 

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Disability Overhead Expense: An Overlooked, But Valuable Coverage

Most professionals and executives carry a substantial amount of disability income insurance, paid with personal dollars, employer funds, or a combination of the two. Often overlooked is a related type of coverage which can be extremely important and yet is relatively inexpensive: Disability Overhead Expense Insurance.

Disability Overhead Expense Insurance is designed to cover ongoing expenses of a business in the event of the disability of a key income producer. Like disability income insurance, it involves an elimination period (normally 30 or 60 days), and a benefit period (12 to 24 months). Should the insured become totally disabled (as defined by the policy), the amount of monthly expense purchased would be paid to the practice once the chosen elimination period is satisfied. The funds would be available to cover ongoing expenses such as rent, utilities, non-professional salaries, etc.

This type of coverage serves an important purpose, since it provides for a pool of funds to cover continuing office expenses while the disabled individual recovers. Without the disability overhead expense insurance coverage, those expenses would normally need to be paid from current cash reserves and/or a portion of any disability income insurance benefits received. The latter obviously reduces the income available to the individual during a period of disability.

Since the benefit period for a Disability Overhead Expense Insurance policy is relatively short, the associated premiums are substantially lower than for disability income insurance.

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This publication is not meant to provide legal or other professional advice. It is suggested that a tax advisor be contacted to review applicable areas discussed herein. All rights reserved.