Understanding the New Roth 401(k)

Understanding the New Roth 401(k) Transamerica®. The retirement answer. Presented by Crystal Gravitt and Jonathan Anderson

TRANSAMERICA RETIREMENT SERVICES ® Transamerica Retirement Services (Transamerica or TRS), a marketing unit of Transamerica Financial Life Insurance Company and other of its affiliates, specializes in the promotion of retirement plan products and services.

Agenda The Basics • What is a Roth 401(k) and how does it work? • Comparison of Features Compliance and Recordkeeping Plan Sponsor Considerations What Participants Need to Know Reasons to Consider a Roth 401(k) Comparison of Pre-tax 401(k), Roth 401(k), and Roth IRA Conclusions

Introduction New “Roth 401(k)” available January 1, 2006 Participants may elect to contribute all or part of contributions as after-tax (Roth 401(k))or before-tax (“regular” or pre-tax 401(k)) Pre-tax 401(k)accumulates income 100% tax-free until distribution. At distribution, the entire amount (pre-tax 401(k) plus accumulated income) is taxed. Roth 401(k) accumulates income 100% tax-free. At distribution, a qualified distribution is 100% income tax-free(includes Roth 401(k) plus accumulated income) “Pay Uncle Sam Now or Pay Him Later?”

Roth 401(k) Basics Roth 401(k) Basics • Eligibility Restrictions - No AGI Limit • Contribution Tax Treatment and Limits • Same as pre-tax 401(k) ; subject to FICA • $15,000/$5,000 for 2006 (subject to COLA adjustments) • Combined Limit for pre-tax 401(k) and Roth 401(k). For 2006, a participant not eligible to make catch-up contributions could: • Make $15,000 of pre-tax 401(k) only, or • Make $15,000 of Roth 401(k) only, or • Any combination of pre-tax 401(k) and Roth 401(k), so long as the combined total is $15,000 or less. • The numbers above assume the participant was not otherwise limited by the plan or other limits. • Distributions • Qualified distributions are 100% tax-free. A qualified distribution is one that is: • Made after a 5-taxable-year period of participation, and • Is made after the employee attains age 59 ½, becomes disabled, or dies. • A non-qualified distribution (other than a qualified distribution) will result in a partial tax-free distribution.

Roth 401(k) Basics Roth 401(k) Basics Example : Roth 401(k) five-year Rule • July 1, 2006, Karen, age 58, first contributes to a Roth 401(k) • She leaves employer in 2007; transfers Roth 401(k) to another Roth 401(k) under a new employer’s plan • Makes first contribution to new employer’s Roth 401(k) plan January 1, 2008 • 1/1/2011 wants in-service distribution from Roth 401(k) account – if plan permits Is the Roth 401(k) distribution tax-free? Yes. Satisfies purpose rule- over age 59½ satisfied 5-year rule - clock starts calendar year of 1st contribution (2006) (5-year rule is carried over to new Roth 401(k))

Comparison of Features Comparison Chart *Some 401(k) plans have the RMD date as the later of 70-½ or termination from employment if not a 5% owner ♦Does not include $5,000 additional catch-up contribution limit in 2006

Compliance & Recordkeeping Recordkeeping Roth 401(k) Contributions • Separate Accounting Requirement • Roth 401(k) contributions and Roth 401(k) rollover contributions will both be maintained as a separate money source • Must be maintained separately until entire account is distributed • Contributions, gain/losses, and expenses will be reflected in the Roth 401(k) accounts • Roth 401(k) accounts will be reflected separately on the participant quarterly statements and on the Web • Contribution File layouts will be modified to accept Roth 401(k) contributions • Track first contribution date – to determine qualified distributions

Plan Sponsor Considerations Should everyone have a Roth 401(k)? Issues MEP Sponsors should consider before adding a Roth 401(k): • More complex enrollment process • More complex distribution process • Is employee interest strong enough to warrant a Roth 401(k) • Sunset Provision – will the Roth 401(k) be around in future years

Targeting New Client Companies • Employers who may be suitable for a Roth 401(k) feature: • Business owner clients looking for more “spending power” in retirement • Niche businesses such as medical practices and law firms • Businesses with a younger employee population • Businesses with employees who have previously been excluded from contributing to Roth IRAs because their income level was too high

Targeting New Client Companies • Employers who may be suitable for a Roth 401(k) feature continued: • Employers who would like to offer a more competitive retirement program • Employers who would like to give plan participants more independence concerning retirement plan contributions, tax deductions and when to pay taxes

Plan Sponsor Considerations What MEP Sponsors Should Consider • Employee Communications should include: • Individual Contribution Limits • Same Investment Options and Participant Rights • Difference in Paycheck • How Marginal Tax Rate Impacts Choice • Impact on Employer Match • Rules for Qualified Distributions • Charts As when 401(k) & Roth IRA 1st Available; Foreign Now, Familiar Soon • Business Owner and Key Personnel Needs • Employer Feasibility Study • Recordkeeping & Compliance; Employee Communications • Implementation Schedule; What Will It Cost?

Targeting Employees • Employees who may be suitable for a Roth 401(k) feature include: • Employees who believe they will be in a higher tax bracket in retirement • Employees who have been excluded from contributing to a Roth IRA because of their income level • Employees looking for Estate Planning Tools • Younger employees

Focus on Participants What Participants Need to Know • Marginal Tax Rate (“MTR”) • Employee contributions and Employer Match • Sunset Impact: Need to compare benefits resulting from next 5 years of 401(k) vs. Roth 401(k) contributions during retirement

Focus on Participants What Participants Need to Know • Employer Match: Lower Roth 401(k) may not Qualify for Highest Available Match Example: Roth 401(k) May Not Qualify for maximum Match George, 15% MTR, contributes 6% or $1,740 of $29,000 pay to pre-tax 401(k) option; Employer matches $.50 for each dollar up to 1st 6% on pre-tax 401(k) or the new Roth; George receives maximum $870 match on current pre-tax 401(k) contribution Will George receive maximum match if Roth 401(k) contribution based on same salary reduction percentage?

What Participants Need to Know No. A Roth 401(k) of 6% of compensation is a net $1,479, compared to a 6% pre-tax 401(k), which is $1,740. For a Roth 401(k), George’s pre-tax compensation of $29,000 is (1) multiplied by George’s MTR of 15%, which results in after-tax compensation of $24,650, and then (2) George’s 6% Roth 401(k) is determined based upon after-tax compensation, resulting in a contribution of $1,479 (compared to pre-tax 401(k) of $1,740 at 6%). Match on $1,479 is only $739.50.

What Participants Need to Know • Assumptions: • $29,000 earnings • 6% Contribution • .50/1.00 match for first 6% contribution 6% Contribution Match Pretax $1,740.00 $870.00 Post Tax $1,479.00 $739.50 • Difference of $391.50 in Total Savings today • Difference of $130.50 in Employer Match

Who Should Consider Tax Rates for 2006 Each row represents a "Tax Bracket." *Charles’ current tax bracket in yellow. * This is a Hypothetical Tax Illustration – not actual data

Who Should Consider Charles retires in 2020, receives $100,000/year. Based on hypothetical* taxrates for 2020, it turns out that Charles** was correct; he is in a lower tax bracket; however, he pays federal income tax at a higher rate during retirement than he did back in 2006. Hypothetical* Tax Rates for 2020 * This is a Hypothetical Tax Illustration projected for 2020– not actual data

Rules Rules • Five-year rule For qualified distributions, the law mandates the five-year holding period. • Tracking Contribution Basis It is clear that the plan sponsor is responsible for tracking the contribution basis while the Roth 401(k) account remains in the plan, and that individual account owners are responsible for this for Roth IRAs.

Rules Rules • Plan Amendment to add Roth generally required by last day of 2006 plan year. Off-calendar plans may offer Roth on and after 1/1/06 and before beginning of 2006 plan year if amendment is adopted on or before date Roth contributions start. • Loans: Repayments subject to the same rules (level payments made at least quarterly); the total vested balance (Roth and non-Roth) is aggregated in determining maximum loan amount; if loan defaults, deemed distribution treated as nonqualified distribution for any Roth funds involved, even if the Roth funds otherwise met the requirements for a qualified distribution.

Rules Rules • Automatic EnrollmentAutomatic enrollment may be used in conjunction with Roth 401(k) contributions. The plan document must state the extent to which default contributions are irrevocably designated as Roth 401(k) contributions or pre-tax 401(k) contributions. • Option Change FrequencyThe rules relating to the frequency of elections (to make, change or suspend) pre-tax 401(k) contributions also apply to Roth 401(k) contributions

Rules Additional IRS Guidance Required • Interaction between Roth 401(k) with safe harbor rules • 402(f) Notice • Form W-2 • Separate IRS Form 1099-R • Additional rollover notification requirements • Model amendment

Reference Guides Comparison of Plans – Advantages / Disadvantages For a Plan Sponsor 1. Roth 401(k) requires separate recordkeeping 2. Roth 401(k) is added – the Plan Sponsor must create and distribute a formal communication plan to employees.

Reference Guides Comparison of Plans – Advantages / Disadvantages For a Participant 1. A maximum Roth 401(k) contribution entails paying more upfront to cover the taxes, therefore an equivalent before-tax contribution would require taking the taxable amount for an equivalent Roth 401(k) contribution and investing it in a separate taxable account over that same period. 2. With the addition of the Roth 401(k) feature to a plan, participants may choose to diversify their tax risk by allocating contributions to both before-tax and after-tax accounts. 3. A Roth 401(k) accounts may be rolled over to a Roth IRA, which has no Required Minimum Distribution requirement.

Reference Guides Comparison of Plans – Roth 401(k) & Roth IRA

Conclusions Conclusions • No “one size fits all” answer to question: • “Pay Uncle Sam Now or Pay Him Later?” • Knowledge of rules and contingency projections provide meaningful guidance You don’t need a crystal ball to see thatthe Roth 401(k) may afford significant retirement and estate planning opportunities.

Points to Discuss with Prospective Client Companies • Structure your discussion around these four topics: • Tax considerations • Estate planning benefits • Contributions • Flexibility

Points to Discuss with Prospective Client Companies • Tax Considerations • Do you have employees who believe their personal tax rate will rise in the future? • Do you believe tax rates will rise in the future? • Is your employee base predominantly lower-paid and younger in age? • Estate Planning • Do you have employees who may wish to preserve assets for their heirs by rolling over their Roth 401(k) assets to a Roth IRA to avoid Required Minimum Distributions?

Points to Discuss with Prospective Client Companies • Contribution Impact • Do you have employees looking to pre-pay their tax liability during their working years? • Are some of your employees looking to maximize their retirement benefits by “grossing-up” their salary deferrals by the tax deduction they would have received in a traditional 401(k) retirement program? • Do you believe some of your plan participants are aggressive investors who will be seeking to take advantage of tax-free earnings at retirement?

Points to Discuss with Prospective Client Companies • Flexibility • Do you believe some of your employees would benefit from the choice of investing on both a pre-tax and after-tax basis? • Do you have higher income employees who were previously excluded form contributing to a Roth IRA due to income limitations, and are looking for the added flexibility of a Roth 401(k)? • Do you have highly-compensated employees who have been restricted in the amount of money they are able to contribute? • Do you have highly-compensated employees who had their pre-tax contributions returned because the plan did not meet testing requirements? • If possible, would your key employee be interested in ways to maximize their annual contributions?

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Understanding the New Roth 401(k)