| 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.
Annual Salary: $50,000
Total Available for Savings: $5,000 |
| |
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.
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