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Retirement plans are among the best tax shelters available. Contributions are made on pretax basis; employers’ match is deductible by the employer but not taxable to employees till distribution is taken by the employee; growth is tax-deferred and funds get accumulated for retirement needs.


Roth IRA contributions are not deductible; for 2006, the combined limit for contribution to traditional and Roth IRA is lesser of $4,000 ($5,000 if age 50 or older) or earned income, and qualifying distributions are not taxable. However, Roth IRA contributions are subject to a modified AGI limitation. The phase-out range is $150,000 to $160,000 for married filing jointly, and $95,000 to $110,000 for single. Thus, taxpayers with high AGI can’t contribute to Roth IRA. That is where 401(k) Roth comes into play.

401(K) ROTH:

Beginning in 2006, a 401(k) plan may allow employees to designate some or all of their elective contributions as Roth contributions. Traditional salary deferral or 401(k) contribution by employees is excluded from employees’ taxable wages. But amounts designated as Roth contributions are includable in taxable wages. However, a qualified distribution of designated Roth contributions and related earnings are free from federal income taxation.


Before a plan can accept Roth contributions, the plan must be amended to allow for separate tracking of the Roth contributions. IRS has provided sample plan language that can be used to amend existing 401(k) plans. However, a plan is not obligated to provide for Roth contributions.

Roth 401(k) accounts will generally be more advantageous than regular Roth IRA accounts. For high-income individuals, there is no AGI limitation to restrict participation in Roth 401(k). For year 2006, regular 401(k) and Roth 401(k) contribution limit is $15,000. For participants 50 or over, this limit is $20,000. Pretax matching contribution by employer can be made to a designated Roth IRA account.


If an employer has provided this option, then how much amount should one elect as Roth contribution? Roth 401(k) plans are scheduled to sunset on Dec. 31, 2010. That means Roth contributions could remain in the plan but no new contributions would be made. However, these provisions could be extended also. At a minimum, those who were in high AGI and could not contribute to Roth IRA now have that option if the employer plan provides for it.


To convert a traditional IRA to a Roth IRA, the taxpayer’s modified AGI for the year of conversion must be $100,000 or less. This applies to all filing statuses except married filing separate, in which case conversions are not allowed. Taxpayers recognize taxable income at the time of the conversion but future growth is tax-free, and no minimum distribution is required at age 70½.


For year 2010 and beyond, $100,000 AGI restriction on Roth conversion will be eliminated because of a favorable provision in the Tax Increase Prevention and Reconciliation Act of 2005 (TIPRA). It also provides that federal taxes owed from 2010 conversions can be paid in two equal installments in 2011 and 2012. For conversions after 2010, the conversion taxes owed can’t be stretched.

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. Parveen Maheshwari, C.P.A., can be reached at (650) 340-1400