Roth Deferrals For 401(K) Plans: Employers Should Know All Their Options
By: Chad Halbur
Effective January 1, 2006, employers were able to permit participants to make Roth 401(k) contributions to their 401(k) plans. Although the Roth 401(k) has certain advantages, employers should be aware of the tax and administrative considerations prior to incorporating this provision in their plans.
What are Roth 401(k) Deferrals?
A Roth 401(k) is a plan provision that is now available in a 401(k) retirement plan and the tax treatment is similar to that of a Roth IRA. For example, when a contribution is made a Roth 401(k) or Roth IRA, the individual does not receive an income tax benefit upon making the contribution; instead the benefit comes at the time of withdrawal. The account grows tax-free and the participant pays no income tax on the principal or earnings at the time of qualified distributions. The Roth 401(k) feature may be appealing to participants, especially those who are younger with higher incomes.
The Roth 401(k) has two advantages over the Roth IRA.
- The maximum contribution to a Roth 401(k) is greater than the Roth IRA. For example, in 2008, an individual may contribute $5,000 annually (or if over the age of 50 may contribute $6,000 annually) to a Roth IRA. That same individual could contribute up to $15,500 (or if over the age of 50, may contribute $20,500) to his or her employer’s Roth 401(k).
- Higher income individuals with an Adjusted Gross Income (AGI) greater than $166,000 for joint filers and $114,000 for single filers may use a Roth 401(k). These individuals may not contribute to a Roth IRA because their AGI exceeds the Roth IRA contribution phase-out amounts.
- A Roth 401(k) feature does not increase the maximum amount a participant may defer annually into a 401(k) plan. For example, the deferral limit for 2008 is $15,500; the participant cannot double up by making a traditional tax favored 401(k) deferral of $15,500, plus another $15,500 Roth 401(k) contribution. The amount of the Roth deferral offsets the available limit on the traditional 401(k) deferral.
- In order for a participant to use a Roth deferral, he or she foregoes the favorable tax treatment of a traditional 401(k) deferral. For some participants, this tax trade-off may not be to their advantage. On the other hand, the Roth deferral may work well for younger participants or those participants who will be in a higher income tax bracket at retirement.
- The Roth 401(k) is subject to minimum required distributions at age 70½. The Roth IRA is not. Of course, one could always rollover their Roth 401(k) to a Roth IRA to avoid this issue.
- There is no assurance that Roth contributions will remain tax-free upon withdrawal. Congress has the ability at any time to change the rules. Other than political pressure, there is nothing to prevent Congress from making these dollars subject to tax in the future.
- Roth 401(k) deferrals are treated like a traditional 401(k) deferral for all testing purposes. For example, Roth 401(k) deferrals will be included in non-discrimination testing, such as the ADP test, and are subject to any match.
- Employers will need to modify procedures and forms to track whether an employee has elected to make a tax-deferred 401(k) deferral or an after-tax Roth deferral.
- Employers will need to educate employees on the difference between a Roth deferral and a traditional 401(k) deferral.
- In order to implement the Roth feature, employers must amend their plans.
- Employers will need to work with their payroll provider to establish another payroll deduction field.
When will Roth 401(k) be available?
The tax code permits the use of Roth 401(k) deferrals as of January 1, 2006. The IRS released final regulations on designated Roth contributions on December 3, 2005. They then followed up with final regulations on distributions and taxation of Roth assets on April 30, 2007. With this information the retirement plan industry now has the information necessary to begin implementing Roth deferral programs in defined contribution 401(k) plans. Remember it is necessary to amend your plan document to allow for this new plan feature.
As always, Cornerstone Private Asset Trust Company, LLC appreciates the opportunity to keep you up to date on important law changes. If you should have any questions or wish to discuss the Roth 401(k) feature in more detail, please feel free to contact us at 866-200-6528.