Roth Contributions to 401(k) and 403(b) Plans

Nothing contained in this outline is intended, written to be used, or to be construed as tax advice or guidance.

The ability to make Roth contributions to 401(k) plans and 403(b) plans became effective for taxable Plan years beginning on or after January 1, 2006. If permitted by plan provisions, participants may designate that all or a portion of their elective deferrals be treated as Roth contributions. The designated Roth elective deferral contributions are subject to current income tax while qualified withdrawals of both contributions and income are tax-free.  It is important to note that Employer matching contributions made as a result of both Roth and pre-tax contributions are taxable upon distribution unless rolled over.  Matching contributions are tax deductible to the Employer, therefore do not follow the same taxation rules as Employee Roth deferrals.

Roth 401(k) Contribution Features:

  • Elective contributions that are made after tax (also 100% vested)
  • No income limits (Roth IRA's have income limits)
  • Designated irrevocably whether pre-tax or after-tax by employee at time of deferral elections
  • Combination of pre-tax and Roth 401(k) subject to 402(g) limits 
  • Subject to ADP testing unless 403(b). If ADP test fails, HCE can designate whether corrective refunds come from Roth or Pre-tax. Earnings are taxable. (This testing could limit highly compensated employees)
  • Subject to top heavy, annual additions rules, etc. (contact Paragon for details)
  • Separate accounting is required by your payroll provider and record keeper
  • Roth contributions and earnings are not taxable upon qualified distribution (distributions are qualified only after: 5 years of deposit AND age 59½, death or permanent disability)
  • Largely the same distribution restrictions as 401(k) pre-tax deferrals (includes age 72 required minimum distributions, while Roth IRA's do not).
  • Upon distribution, balances can be rolled over TO another designated Roth 401(k) account or Roth IRA
  • Cannot roll Roth IRA balance INTO a Roth 401(k)
  • Roth in-plan conversions allowed effective January 1, 2013. (If provision is in plan, eligible participants can convert pre-tax to Roth and pay applicable taxes)

Items needed before implementation:

  • Amend your plan document to include Roth provision
  • Payroll systems must be able to accommodate Roth contributions
  • Recordkeeping systems must be able to track Roth 401(k)'s separately
  • Obtain employee communication tools and forms from plan service providers
  • If utilizing auto cash out provision (more than $1,000 and less than $5,000) must be able to rollover to Roth IRA

Roth Summary:

This provision includes some powerful tax benefits and planning opportunities that could be worthwhile for some plan participants. The economic benefit of a Roth 401(k) as opposed to the traditional 401(k) deferral really is impacted by the tax brackets in place when dollars are contributed and withdrawn. In most cases where the tax brackets are equal, there is not a significant economic benefit to either method. The reason for this is that in order to save under the Roth 401(k), more real dollars have to be saved since there is no immediate tax advantage on the actual contribution. 

Since the provision has been in place since 2006, administration of the Roth feature has become easier.  If implementing the Roth provision, your advisor and enrollers should be able to effectively communicate the basic differences of the pre-tax and Roth features to employees. Thorough employee communication and participation at most pay levels will be required for the feature to be a success.  Generally CPA’s preparing tax returns for participants are the most capable in addressing the pros and cons for their tax clients.

Who could benefit:

  • Certain highly compensated employees (HCE's) are not allowed to participate in a Roth IRA due to income limits. These HCE's may wish to bypass today's tax savings in order to receive tax free distributions at retirement.
  • Employees who wish to defer more dollars on an after-tax (Roth) basis (limits can be found here)
  • Lower income taxpayers that understand the benefits (i.e., may be in a much higher tax bracket when they retire). Please note these employees are most likely also eligible for a Roth IRA.
  • Participants that roll Roth 401(k) accounts into Roth IRA's may avoid minimum required distributions (70 1/2) prior to death.