Thanks to the popularity of the Roth IRA, many people are familiar with how Roth accounts work. As opposed to most retirement accounts where contributions are made pre-tax and withdrawals are taxed, Roth accounts are funded with after-tax money and qualified withdrawals are not taxed.
What many don’t realize is that Roth accounts are available for workplace retirement plans, not just IRAs. The IRS allows designated Roth accounts in 401(k), 403(b), and governmental 547(b) retirement plans. However, they are not permitted in SARSEP or SIMPLE IRA plans. A traditional account option must also be available in order to offer a Roth account.
Contributions
Many plan sponsors hesitate to include a Roth option in their retirement plans because they don’t want to make their employees have to choose between Roth and traditional accounts. Their fear is unfounded, however, because both kinds of accounts can be contributed to in tandem; they are not mutually exclusive.
Contribution limits for 401(k)s, 403(b)s and 457(b)s combine all accounts, both Roth and traditional. For 2017, the limit per person is $18,000, or $24,000 for those age 50 and over. Contributing to a workplace Roth account does not affect a worker’s eligibility to contribute to a Roth IRA, though income limits do apply. If they meet the income requirements, workers may contribute to both their workplace Roth account and a Roth IRA for a total of $23,500, or $30,500 if eligible for catch-up contributions. Unlike with the IRA, there are no income limits for workplace Roth eligibility.
Employer Matches
Plan sponsors are allowed to match employee contributions made to Roth accounts. However, the employer match doesn’t go into a Roth account itself. Only designated Roth contributions and rollover contributions can go into a Roth account. All employer contributions and forfeitures go into a pre-tax account.
If the plan allows for it, a worker can choose to rollover their employer contributions into their Roth account within the same plan.
In-Plan Rollovers
In-plan rollovers may be allowed if stated in the plan documents. Even if not eligible for distribution, any vested balance can be rolled over, including earnings. This can include elective deferrals, matching contributions, nonelective contributions, rollover contributions, and after-tax employee contributions. The plan should specify what exactly is eligible to be rolled over and how frequently.
Plan sponsors are not required to withhold income taxes on in-plan Roth direct rollovers. The 20% federal withholding requirement only applies to distributions, even if they are later rolled into a designated account within 60 days. Plan participants are responsible for including the taxable amount of their in-plan Roth rollover in their gross income for tax purposes.
Withdrawals
Distributions from a Roth account can either be qualified, in which case no taxes are due, or non-qualified, in which case earnings are included in taxable gross income. To be qualified, a distribution must be made after a 5-taxable-year period of participation and after the participant’s 59 ½ birthday, death, or becoming disabled.
The 5-taxable-year period begins on the first day of the tax year in which the first Roth contributions were made. It ends after 5 consecutive tax years. If a plan participant rolls funds over from a different plan’s Roth account, the 5-taxable-years period can be carried over from when contributions were first made to the other account.
Some distributions are never qualified and the earnings paid are always taxed. Corrective distributions from excess contributions or deferrals and deemed distributions are never qualified. Neither are withdrawals made before the end of the 5-taxable-year period. Even if the plan permits hardship distributions, the earnings portion is taxed unless the participant meets the age or disability requirements and the 5-taxable-year period is over.
Compliance
The annual nondiscrimination testing for your retirement plan will include Roth contributions as well as traditional, pre-tax elective contributions. They are treated the same for compliance testing and determining if a plan is top-heavy.
If your plan fails the nondiscrimination test and your highly compensated employees take a corrective distribution, you get to decide whether or not they can elect which account to take it from. This option should be written into your plan document.
It can benefit employees to have the option because if their corrective distribution comes from a designated Roth account, it will not have to be included in gross income for the tax year. The income used to make the contribution is still taxable and included in their gross income.
How We Can Help
Including a designated Roth option in your company’s retirement plan may be a wise move. They can be of great benefit to participants, especially younger workers who have more time for their savings to grow.
If you have any questions about designated Roth options or think your retirement plan needs one, give us a call at (312) 973-4911 or email info@planpilot.com. We are highly experienced retirement plan consultants and can answer any questions you have or help you amend your plan to include a Roth option.
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