In a Roth 401(k) plan, participants make after-tax contributions to a qualified plan and receive tax-free distributions, provided the funds are in the plan for at least five years from the date of the initial Roth 401(k) plan contribution. Thus, while participants pay a tax on the income that was the source of the contribution, the earnings on the contributions are tax-free. Is the option of a Roth 401(k) plan right for your qualified plan?
Enter the Roth Option
Roth IRAs have been around since 1997, and Roth 401(k) plans became a reality under the Pension Protection Act of 2006. The ability to convert existing pretax balances within a 401(k) to Roth status was expanded by the American Taxpayer Relief Act of 2012.
The contribution rules for a Roth 401(k) plan are exactly the same as the rules for a traditional, pre-tax 401(k) plan. Participants younger than 50 years old can contribute a maximum of $18,000 in 2015. If participants are 50 or older, they can make an additional “catch-up” contribution of as much as $6,000, for a total of $24,000 in 2015. These contribution limits are adjusted annually.
Converting to a Roth 401(k)
Generally, it is easier for participants to start making after-tax contributions to a Roth account within their 401(k) plan than to convert a significant existing pretax amount to the plan’s Roth component. This is because, similar to an IRA conversion, a Roth 401(k) conversion triggers a tax liability that participants must pay on the conversion. If the participants need to raise the cash from retirement funds and they are younger than age 59½, they would get to keep only 90% of the amount after the 10% premature withdrawal penalty, less whatever amount regular income taxes would take.
Age Makes a Difference
The participant’s age also factors into the use of a Roth 401(k) plan option. A young participant, especially one who is not a high-income earner, may opt for a Roth 401(k) plan because while they are giving up the initial tax break on their contributions, the tax break would not have been that significant if they are currently not in a high tax bracket. Additionally, the Roth 401(k) plan options allow young participants to avoid taxes when they are retired – which is always a good thing. Recent studies have shown an increase in the number of participants in their 20s who are contributing to a Roth 401(k) plan. Given that younger participants have a longer time period to benefit from the buildup of tax-free earnings on their contributions, this makes sense.
There is no way of knowing the tax rates a participant will face upon retirement. If rates are higher, the Roth 401(k) plan after-tax contributions will put the participant ahead of the game. In the unlikely event that the participant’s tax rate will be lower in retirement (an assumption that used to be made but now seems less likely), this tactic may backfire. Given that uncertainty, participants may choose to diversify their account and split their deferrals between both the Roth option and the pretax option in the 401(k) plan.
Making the Roth 401(k) Option a Reality
Giving 401(k) plan participants the opportunity to open a Roth account within a plan — either by starting from scratch or converting some or all of an existing account balance into the Roth structure — may soon become the norm. Giving employees the opportunity to participate in a Roth 401(k) plan may help them hedge their bets about the income tax environment they will face in retirement. If you have additional questions about the Roth 401(k) plan option or best practices for plan sponsors, please contact Ken Kobiernicki at [email protected] or call him at 312.670.7444. Visit orba.com for more information about our Employee Benefits Group.