If your business sponsors a 401(k) plan, you might someday consider adding designated Roth contributions. Here are some factors to explore when deciding whether such a feature would make sense for your company and its employees.
Roth contributions differ from other elective deferrals in two key tax respects. First, they are irrevocably designated to be made on an after-tax basis, rather than pretax. Second, if all applicable requirements are met and the distribution constitutes a ‘qualified distribution,’ the earnings will not be subject to federal income tax when distributed.
To be qualified, a distribution generally must occur after a five-year waiting period, as well as after the participant reaches age 59½, becomes disabled, or dies. Because of the different tax treatment, plans must maintain separate accounts for designated Roth contributions.
Pluses & Minuses
The Roth option gives participants an opportunity to hedge against the possibility that their income tax rates will be higher in retirement. However, if tax rates fall or participants are in lower tax brackets during retirement, Roth contributions may provide less after-tax retirement income than comparable pretax contributions. The result also could be worse than that of ordinary elective deferrals if Roth amounts are not held long enough to make distributions tax-free.
Nonetheless, if your business employs a substantial number of relatively highly paid employees, a Roth 401(k) component may be well-appreciated. This is because participants can make much larger designated Roth 401(k) contributions than they can for a Roth IRA — in 2020 and 2021, $19,500 for designated Roth 401(k) versus $6,000 for Roth IRA.
Catch-up contributions for individuals 50 or older also are considerably higher for designated Roth 401(k) contributions — in 2020 and 2021, $6,500 for designated Roth 401(k)s versus $1,000 for Roth IRAs. In addition, higher-paid participants who are ineligible to make Roth IRA contributions because of the income cap on eligibility could make designated Roth contributions to your plan.
Keep in mind that participants need to know what they are getting into and should consider:
- Current and future tax rates
- Various investment alternatives
- The risk of needing a distribution before they qualify for tax-free treatment of earnings (which would trigger taxation of those earnings)
- Loss of some rollover options
For plan sponsors, the separate accounting required for Roth contributions may raise plan costs and increase the risk of error. (One common mistake: treating elected contributions as pretax when the participant elected Roth contributions, or vice versa).
Also, because Roth contributions are treated as elective deferrals for other purposes — including nondiscrimination requirements, vesting rules, and distribution restrictions — plan administration and communication will be more complex.
Not for Everyone
Before adding Roth contributions to your 401(k), be sure participants are adequately engaged and savvy, and will derive enough benefit, to make it worth the risks and burdens. We can assist you in deciding whether this would be an appropriate move for your business.