Business Owners Should Consider a Roth 401(K)

If you walked around your company’s offices and asked employees what comes after “Roth,” many would probably say “IRA.” Indeed, the Roth IRA has become a well-known type of retirement plan. But you can put “Roth” and “401(k)” together, too, and have a benefits option worth considering.

Value added

Like a Roth IRA, a Roth 401(k) offers tax-free withdrawals but contributions are after-tax. As a result, many employees may find a Roth 401(k) option to be an attractive benefit.

A Roth 401(k) is an add-on to the traditional 401(k) plan. You can’t establish a Roth-only 401(k) plan — your plan must also allow for pretax elective contributions. Employer matching and profit-sharing contributions can be made only to the traditional 401(k) accounts.

Except in certain limited circumstances, participants can’t roll over traditional 401(k) assets into a Roth 401(k) account. Nor can they roll over Roth 401(k) assets into a traditional 401(k) account.

Keep in mind that adding a Roth 401(k) to your retirement plan doesn’t increase the total amount that employees can contribute. The contribution limits are the same for traditional and Roth 401(k) contributions, or the two combined. Roth 401(k) contributions, like employees’ contributions to traditional 401(k)s, are always 100% vested.

About distributions

A Roth 401(k) distribution can occur on a qualifying event. Examples include termination of employment, death, disability and retirement. Your plan document may also permit distributions on reaching age 59½ or for certain hardship situations.

Even though distributions are allowed for any of these qualifying events, the entire distribution — including earnings — may not be tax-free. Distributions of contributions are always tax-free, but a distribution of earnings is tax-free only if it’s a “qualified distribution.” To be a qualified distribution:

The participant must meet the five-year rule. He or she must have held the Roth 401(k) account for five years. The holding period begins on the first day of the calendar year in which a participant makes his or her first Roth 401(k) contribution and ends on the completion of five consecutive calendar years. This is a one-time requirement, not a rolling requirement that separately applies to each year’s Roth 401(k) contributions.

The distribution must have a qualified purpose. This means it must be made after the participant reaches age 59½ or due to his or her disability or death, if earlier.

Employee questions

Employees may ask how a Roth 401(k) will affect their taxes. By forgoing the pretax treatment of the contributions, participants can generally avoid having to pay taxes on distributions.

Doing so benefits participants who’ll be subject to a marginal tax rate in retirement that’s at least as high as their rate when they made the contributions. With traditional 401(k) contributions, the taxes are deferred until distributions are taken. This benefits participants who’ll be taxed at a significantly lower rate during retirement.

Because it’s hard to predict what the future will bring, participants sometimes split the amount they contribute between a Roth 401(k) and a traditional 401(k). If you choose to offer a Roth 401(k), advise your employees to consult with their financial advisors to determine whether this type of plan suits their financial profile.

Employees may also ask about the difference between a Roth 401(k) and a Roth IRA. For starters, married couples filing jointly with adjusted gross incomes (AGIs) exceeding $169,000 per year or singles with AGIs exceeding $122,000 can’t contribute to a Roth IRA, and taxpayers with AGIs nearing those amounts are subject to a contribution phaseout. On the other hand, there are no AGI limits on Roth 401(k) contributions.

Roth 401(k)s also permit much higher contributions than Roth IRAs. For 2011, the limits are $16,500 vs. $5,000, respectively ($22,000 vs. $6,000 for taxpayers age 50 and older).

The five-year holding rule applies to both. However, Roth IRAs aren’t subject to required minimum distributions (RMDs) after age 70½, while Roth 401(k)s are. And, on a qualifying event, participants can roll over a Roth 401(k) into a Roth IRA to eliminate RMDs.

Your call

A Roth 401(k) could give a boost to your benefits package that helps you attract or retain key employees who may not be eligible to contribute to a Roth IRA. But, as an add-on benefit, it may “add on” some administrative time and expense. It’s your call.

Please contact Feeley & Driscoll's Boston Accounting team by Email or call us at 1 (888) 875-9770.

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