For more than a decade, plan sponsors have been able to amend their 401(k) plans to include a post-tax deferral contribution called Roth, but only about 86 percent of plan sponsors have made it available to participants, according to the Plan Sponsor Council of America. Despite the potential benefits of a Roth, only a quarter of participants who have access to the Roth 401(k) option use it. Plan sponsors may want to consider adding a Roth 401(k) option to their lineup because of the potential tax benefits and other advantages for plan participants.
A well-designed Roth 401(k) may be an attractive option for many plan participants, and it is important for plan sponsors considering such a feature to design the plan with the needs of their workforce in mind. Plan sponsors also need to clearly communicate the differences from the pre-tax option, including specific timing rules required and the tax-free growth it offers. Additionally, plan sponsors should be mindful of potential administrative costs and other compliance requirements in connection with allowing the Roth option.
Roth 401(k): the details
A Roth is a separate contribution source within a 401(k) or 403(b) plan that differs from traditional retirement accounts because it allows participants to contribute post-tax dollars. Plan participants may make qualified withdrawals of Roth monies on a tax-free basis since they pay taxes on these contributions prior to them being invested in the account. The accounts grow tax-free as well.
In 2023, participants of any income level may participate in a Roth 401(k) and may contribute a maximum of $22,500 – the same limit as a pre-tax 401(k). Contributions and earnings in a Roth 401(k) may be withdrawn without paying taxes and penalties if participants are at least 59½ and it has been at least five years since the first Roth contribution was made to the plan. Participants may make catch-up contributions after age 50, and they may split their contributions between Roth and pre-tax. Similar to pre-tax 401(k) accounts, Roth 401(k) assets are considered when determining minimum distributions required at age 72, or 70½ if they reached that age by January 1, 2020.
Only employee elective deferrals may be contributed post-tax into Roth 401(k) accounts. Employer contributions made by the plan sponsor, such as matching and profit sharing, are always pre-tax contributions. If the plan allows, participants may convert pre-tax 401(k) assets into a Roth account, but it is critical to remember that doing so triggers taxable income and participants must be prepared to pay any required tax. In addition, plan sponsors must be careful to offer Roth 401(k)s equally to all participants rather than just a select group of employees.
Qualified distributions from a designated Roth account are excluded from gross income. A qualified distribution is one that occurs at least five years after the year of the employee’s first designated Roth contribution (counting the first year as part of the five) and is made on or after age 59½, on account of the employee’s disability, or on or after the employee’s death. Non-qualified distributions will be subject to tax on the earnings portion only, and the 10% penalty on early withdrawals may apply to the part of the distribution that is included in gross income.
Related Read: A Look at the Roth IRA Five-Year Rule
First steps for plan sponsors
A common misconception among plan sponsors is that a Roth offering requires a completely different investment vehicle. The feature is simply an added contribution option; therefore, no separate product is needed.
When considering the addition of a Roth 401(k) option, it is important for plan sponsors to check with service providers to determine whether payroll may be set up properly to add a separate deduction for the participant. Plan sponsors may also need to consider guidelines for conversions, withdrawals, loans and other features associated with the Roth contribution source to ensure the plan document is prepared and followed accurately.
Education is an important component of any new plan feature or offering. Plan sponsors should check with service providers to see how they may help to explain the feature and optimize its rollout for the plan. One-on-one meetings with participants may be very helpful in educating them about a Roth account. At a minimum, plan sponsors should offer annual meetings for employees with the service provider and share contact information if participants have questions.
A word about conversions
If permitted by the plan document, participants may convert pre-tax 401(k) plan assets (deferrals and employer contributions) to the Roth source within their plan account. The plan document may allow for entire account conversions or just a stated portion. When assets are converted, participants must pay income taxes on the converted amount, and the additional ten percent early withdrawal tax will not apply to the rollover. Plan sponsors should educate participants on the benefits of converting to the Roth inside the company 401(k).
Related Read: Should You Convert Your Balance to a Roth IRA?
Insight
The right service providers may review your current plan design, set up accounts properly, actively engage and educate your participants and offer financial planning based on individual circumstances to show how design features like a Roth account may benefit their situation. If you would like to start the conversation about adding a Roth option or enhancing your participant education program, we are available to help.
For more information, contact Stephanie Zaleski-Braatz at [email protected] or 312.670.7444. Visit ORBA.com to learn more about our Employee Benefit Plans Services.