Designated Roth
contributions (a/k/a Roth 401(k) or Roth deferrals) have been available
since 2006, but a change in the tax laws governing Roth IRAs has reenergized
discussions about this feature. This article is in Q&A format and addresses
some of the more common questions about Roth 401(k) contributions. But
first, a brief overview…
Traditional deferrals reduce a participant's income for federal and, in
most cases, state tax purposes at the time of contribution. Those amounts
grow on a tax-deferred basis until the participant takes a distribution,
which is taxable as ordinary income. Roth deferrals are fully taxable to the
participant at the time of contribution. However, if certain requirements
are met, so-called "qualified distributions" of Roth deferrals and the
earnings thereon are completely tax free.
Apart from the tax differences, Roth deferrals are treated the same as
traditional deferrals for all plan purposes. The normal limits and
non-discrimination requirements apply. Roth deferrals are also subject to
the same withdrawal restrictions, i.e. death, disability, retirement,
financial hardship, etc.
What types of plans can allow Roth deferrals?
Both 401(k) and 403(b) plans can include a Roth component.
Are there any income restrictions preventing higher wage earners from
making Roth 401(k) contributions?
No. Unlike Roth IRAs, any employee eligible for the plan can make Roth
deferrals regardless of income.
What are the limits on the amount of Roth deferrals a participant can
contribute?
The salary deferral limit is $16,500 for 2010. Roth and pre-tax deferrals
are added together for purposes of this limit.
Can catch-up contributions be designated as Roth deferrals?
Yes. Catch-up contributions merely represent an increase in the regular
deferral limit for those who are catch-up eligible.
What is all the buzz about Roth conversions in 2010?
Prior to 2010, those above a certain income threshold (generally $120,000
for individuals and $176,000 for married couples) were not permitted to make
Roth IRA contributions. Starting this year, that income cap is removed for
those who wish to convert non-Roth IRAs into Roth IRA accounts. The amounts
converted must be included in taxable income; however, those who convert
during 2010 have the option to spread that tax liability equally over two
years.
Can a participant elect to convert pre-tax 401(k) deferrals into Roth
401(k) deferrals?
No. The regulations make it very clear that when a participant elects to
make pre-tax deferrals, that election is irrevocable. While the participant
may change how future contributions are designated, existing contributions
cannot be converted within the plan. However, there has been discussion on
Capitol Hill about changing the law to allow conversions inside the 401(k)
plan similar to the IRA conversions that are allowed beginning in 2010.
Can Roth 401(k) accounts be directly rolled over into another 401(k)
plan or a Roth IRA?
Yes. Roth accounts from a qualified plan or 403(b) plan can be rolled
into another qualified plan or 403(b) plan that allows Roth contributions.
These amounts can also be rolled into a Roth IRA.
Can a Roth IRA be rolled over into a Roth 401(k) or 403(b)?
No. Roth IRAs can only be rolled into other Roth IRAs.
What are the requirements that must be satisfied to receive a tax-free
distribution from a Roth account?
A participant must complete a so-called five-year period and the
distribution must occur on or after attainment of age 59½, death or
disability. A tax-free Roth distribution is referred to as a qualified
distribution.
What is the five-year period and when does it start?
The five-year period is generally a holding period a participant must
satisfy to take a qualified distribution. It begins on the first day of the
first taxable year in which a participant first makes Roth deferrals to the
plan. For example, if a participant makes his first Roth deferral on October
1, 2010, the five-year period starts on January 1, 2010.
Is the plan sponsor or the participant responsible for tracking the
five-year period?
Plan sponsors and their service providers are required to track the Roth
five-year period as well as the amount of basis for each participant. This
requirement is likely to present significant record-keeping challenges,
especially in takeover situations.
Does the five-year period start over when a participant goes to work for
another company and makes Roth deferrals into his new employer's plan?
It depends. If the participant rolls over his Roth account to the new
plan, the portion of the five-year period already satisfied is transferred
to the new plan. However, if the participant does not roll over the Roth
account, his five-year period starts over with respect to contributions to
the new plan.
Is there any coordination between the Roth 401(k) and Roth IRA five-year
periods?
No. The two five-year periods are determined independently of one
another. Thus, a rollover of a Roth deferral account into a Roth IRA
requires the five-year period to be redetermined.
What happens if a participant takes a loan from the Roth account and
then defaults, requiring deemed distribution of the outstanding balance?
A deemed distribution of a participant loan is never treated as a
qualified distribution even if it occurs after the participant has satisfied
the five-year period and attained age 59½, died or become disabled.
Therefore, the portion of the deemed distribution attributable to Roth is
subject to income tax. To avoid confusion in this area, the loan policy can
be written to restrict participant loans to non-Roth accounts.
Do Roth deferrals affect ADP testing?
Yes. Roth deferrals are included with pre-tax deferrals for purposes of
the ADP test. However, since Roth deferrals are not tax-deductible,
lower-paid participants may be unable to defer at the same level as with
pre-tax deferrals.
Example: Marge earns $50,000 and has
$5,000 available to save for retirement. She is in a combined 25% tax
bracket. If Marge makes pre-tax deferrals, she can contribute the full
$5,000 to the plan. However, if Marge makes Roth deferrals, she must pay
$1,250 (25% of $5,000) in taxes, leaving her with only $3,750 to contribute
to the plan. Since Marge is a non-highly compensated employee, her lower
deferral percentage would have a negative impact on the ADP test.
| |
Pre-Tax |
Roth |
| Income Tax (25%) |
0 |
$1,250 |
| 401(k) Deferral |
$5,000 |
$3,750 |
| Deferral Percent |
10% |
7.5% |
Employers may want to consider a safe-harbor 401(k) plan if they are
likely to experience this situation.
Can availability of Roth deferrals be restricted to those whose incomes
are high enough to maximize their contributions?
No. The availability of Roth deferrals is subject to the minimum coverage
rules for 401(k) plans and the universal availability rules for 403(b)
plans.
Are Roth deferrals considered when calculating the employer matching
contribution?
Unless plan terms specify otherwise, pre-tax and Roth deferrals are both
considered in the employer match calculation. Matching contributions are
always treated as tax-deferred regardless of whether Roth deferrals are used
in the calculation.
Are Roth deferrals subject to Required Minimum Distributions?
Yes. The regulations specifically provide that Roth deferrals are subject
to the required minimum distribution rules. This is in contrast to Roth IRAs
which do not require minimum distributions. It appears that a participant
may avoid required minimum distributions on Roth deferrals by rolling over
these amounts to a Roth IRA prior to the attainment of age 70½.
Do the automatic IRA rollover rules apply to Roth deferrals?
No. Roth and pre-tax accounts are considered separately for purposes of
the automatic rollover rules. Therefore, to the extent the Roth and/or
pre-tax portion of a participant's account is less than $1,000, it is not
required to be automatically rolled over even though the combined vested
account balance may exceed $1,000.
Can a plan that does not otherwise allow Roth contributions accept a
Roth rollover?
No. Regulations clearly state that a designated Roth account can only be
rolled over into another 401(k) or 403(b) plan that has a designated Roth
program.
Is the employer required to report any information at the time Roth
deferrals are contributed to the plan?
Yes. Employers must report Roth deferrals in box 12 of Form W-2 with code
AA for 401(k) plans and BB for 403(b) plans.
How are Roth distributions reported on Form 1099-R?
Roth distributions must be reported on a separate Form 1099-R using Code
B. The non-taxable basis is reported in Box 5, and the beginning of the
five-year period is reported in an unnumbered box next to Box 10.
Are there any reporting requirements for a participant who elects Roth
deferrals?
No. The participant is not required to report any additional information
with respect to Roth 401(k) or 403(b) contributions. However, a participant
rolling over a Roth deferral account into a Roth IRA must keep track of the
rollover amounts and the five-year period with respect to the IRA.
Which is better for participants — Roth or pre-tax deferrals?
The answer to this question depends on each individual's financial
situation and is beyond the scope of this article. Factors such as current
and future tax brackets, estate planning needs and more will impact the
decision, so participants should consult their tax and/or legal advisors for
assistance in reviewing all of the relevant facts and circumstances.
Conclusion
While Roth IRAs are enjoying significant publicity due to the change in
the conversion rules, it is interesting to note that there has not been
significant implementation of the feature in 401(k) plans. According to the
Profit Sharing/401(k) Council of America's 52nd Annual Survey, 36.7% of
plans allowed Roth contributions in 2008; however, only 15.6% of
participants that had the Roth option available elected to take advantage of
it.
Plan sponsors who are considering Roth 401(k) deferrals should consult
with their advisors and service providers to review the potential advantages
and disadvantages that the Roth feature provides.
[top of page]
|
