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Employer Guide to the Roth 401(k)

Just as its name suggests, a Roth 401(k) combines features of a traditional 401(k) with those of a Roth IRA. Similar to a traditional 401(k) feature, a Roth 401(k) feature is offered by employers, but like a Roth IRA, contributions are made with after-tax dollars 

With a Roth 401(k), participants pay tax on their 401(k) contributions at the time of deferral; however, the withdrawals (including the earnings on the Roth contributions) are tax-free if certain requirements are satisfied.

A Roth 401(k) feature is not a separate retirement plan, but a different type of contribution that can be added to an existing 401(k) plan. An employee may contribute to both a Roth 401(k) and a traditional pre-tax 401(k) in the same year in the proportion selected by the employee.

Why should you consider offering a Roth 401(k)?

The advantage of the Roth 401(k) to plan sponsors is the ability to offer additional retirement savings options to employees. Companies without a Roth 401(k) feature may want to add this option to remain competitive with other employers that do allow Roth 401(k) contributions.

In addition, adopting a Roth 401(k) provides your employees with the opportunity to diversify the tax treatment of their retirement savings, since even those individuals who are ineligible for Roth IRAs due to income caps are eligible to contribute to a Roth 401(k).


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What should you consider before offering a Roth 401(k)?

When deciding whether to offer a Roth 401(k) feature, plan sponsors should consider the following:

  • The Pension Protection Act of 2006 made the Roth 401(k) a permanent retirement plan option (it was originally set to “sunset” at the end of 2010).
  • Roth 401(k) contributions and earnings must be tracked separately than pretax 401(k) contributions, and must be held in separate Roth accounts. Because of the additional plan administration involved with Roth contributions, your plan’s record keeper may charge an additional fee for Roth accounts.
  • The plan sponsor should consider whether its payroll system can accept Roth 401(k) contribution elections and process the deductions.
  • Because employee contributions have traditionally been made on a pretax basis, employers that incorporate a Roth 401(k) feature should educate their employees about the Roth 401(k)’s tax features.

 

What are the advantages of a Roth 401(k)?

The following are the benefits of a Roth 401(k):

  • Contributions are taxed at the time of deferral, but distributions (including earnings) are tax-free if five years have passed since the participant first started making Roth contributions to the plan and the distribution is made after age 59½ or on account of death or disability. The five-year period begins on the first day of the taxable year during which the participant first started making his or her Roth contributions to the plan.
  • There is no minimum distribution requirement at age 70½ if Roth contributions are rolled over to a Roth IRA prior to that age.
  • Upon a participant’s death, Roth contributions and earnings may be distributed tax-free to the participant’s beneficiary or estate.
  • Unlike a Roth IRA, there are no income limitations on making Roth 401(k) contributions.

 

Are there disadvantages to a Roth 401(k)?

The following are the potential disadvantages of a Roth 401(k):

  • No current-year tax savings are associated with Roth 401(k) contributions. With traditional 401(k) contributions, participants receive reduced taxable income in the current year. With Roth 401(k) contributions, participants have to wait for any tax benefit.
  • To receive a tax benefit when withdrawing Roth 401(k) contributions and earnings, participants generally have to wait to take a withdrawal until they reach age 59½ and at least five years have passed since they started making Roth 401(k) contributions to the plan.
  • To compare the tax savings of pretax 401(k) contributions and Roth contributions, it is hard to predict if one’s tax bracket will be higher or lower in the future.

 

What are some of the rules associated with a Roth 401(k)?

Below are some rules to be mindful of regarding a Roth 401(k):

  • A worker’s combined pretax 401(k) and Roth 401(k) contributions cannot exceed $18,000 ($24,000 for employees 50 years of age and older) in 2016.  
  • Withdrawals of contributions and earnings are not taxed provided that the account is held for at least five years. Withdrawals are made on account of disability, after death, or on or after attainment of age 59½.
  • Employers may make matching contributions on participants’ Roth 401(k) contributions. Matching contributions accumulate in a separate account that will be taxed as ordinary income at withdrawal.
  • Early distributions of Roth 401(k) contributions are generally subject to the same rules as early distributions of pretax 401(k) contributions.
  • Participants must take minimum distributions beginning the year after they turn 70½.
  • The Roth 401(k) balance can be rolled over into a new employer’s Roth 401(k) or into a Roth IRA if an employee leaves his or her job.
  • Employers with a Roth 401(k) feature may decide to allow in-plan conversion rollovers to Roth accounts. An in-plan conversion rollover allows participants with pretax 401(k) contributions to convert those contributions to Roth amounts while keeping their retirement savings in the plan. In-plan conversions are an optional design choice for the plan sponsor and are not required.
  • Once a participant designates his or her contributions as Roth 401(k) contributions, he or she cannot later change those contributions to pre-tax 401(k) contributions.

 

How does a Roth 401(k) feature compare to a traditional 401(k)?

The primary difference between the two plan features is the way in which contributions are taxed. The contributions made to a traditional 401(k) account reduce the amount of income a participant has to report that year, which results in a smaller tax bill. The participant then pays taxes on those contributions plus all the investment earnings on those contributions upon withdrawal. There is no difference in investment opportunity between the two features.

 With a Roth 401(k), participant contributions do not reduce participant taxes in the year the contributions are made, but all of the earnings in that account will be tax-free as long as the account exists. If certain requirements are satisfied, the participant does not pay tax when he or she receives a distribution of the Roth contributions and related earnings.

 

Which employees should consider the Roth 401(k)?

The answer to this question largely depends on what tax bracket a participant is in today, as compared to which tax bracket the participant expects to be in upon retirement. If the participant is early in his or her career, making a fairly modest salary and anticipates being in a higher tax bracket upon retirement, the Roth 401(k) is appealing because the participant is paying taxes on contributions today at the lower rate. Later, he or she will be able to withdraw that money without paying taxes.

Higher paid participants also can benefit from a Roth 401(k) because they are generally locked out of other savings vehicles such as a Roth IRA that accumulate profits tax-free. The tax-free withdrawals also help highly paid workers manage their tax situation in retirement.

For workers in their 40s and 50s, the choice to contribute to a Roth 401(k) may not be as easy. With the Roth, these participants pay taxes up front when they are in a high tax bracket and then withdraw the money when they are in a lower tax bracket.

All in all, those who will be in a lower tax bracket during retirement are probably better off contributing to a pre-tax 401(k). Furthermore, the longer the amount of time before retirement, the greater the tax benefit, since participants are exempting more investment earnings from taxation.

The chart below compares the major facets of a Roth 401(k) and a traditional 401(k).

Beimdiek Employer Guide 401K Chart

*The contribution limitation is by individual, rather than by plan. Although permissible to split the annual employee elective contribution between Roth contributions and traditional pre-tax contributions, the combination cannot exceed the deferral limit specified above.

At Beimdiek Insurance, we provide a wide range of employee benefits to keep your employees healthy and happy. We provide insight, tools and services to keep your employees engaged in your company for the long-haul. Contact the expert team at Beimdiek for more helpful HR consulting, including thoughts on employee retention, and guidance on reaching your company goals.

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