30-Oct-19
Roth 401(k) plans
Take-Away: Roth 401(k) accounts are similar, but not the same, as a Roth IRA. Additionally, contributions to a Roth 401(k) account are not always treated the same as an after-tax contribution to a Roth IRA account. These different rules can sometimes lead to confusion and missed opportunities.
Background: 401(k) accounts, Roth or traditional, start with what the Tax Code calls a cash or deferred arrangement. This reflects the ability to contribute dollars into a qualified plan, called elective deferrals. Pre-tax contributions to a traditional 401(k) account are excluded from income tax, but are subject to employment taxes. These contributions are also subject to annual contribution limits. For 2019, the maximum contribution is $19,000 with a ‘catch-up’ contribution of $6,000 if the plan participant is over age 50 years, for an aggregate possible annual contribution of $25,000. These dollar contribution limits are per person, not per plan. An employee ‘catch-up’ contribution is also eligible for employer matching contributions. In addition to these pre-tax contributions, a 401(k) plan can also allow Roth 401(k) account to receive after-tax contributions. The Roth 401(k) savings opportunity started in 2006. Having both of these retirement plan contribution options in a single qualified plan [traditional 401(k) and Roth 401(k)] will increase the plan sponsor’s administrative costs, but the Roth option is at the discretion of the plan sponsor.
Roth 401(k) or Roth IRA: Roth 401(k) plans offer the same taxable benefits as Roth IRAs, but they are subject to different rules. In order to adopt a valid Roth 401(k) plan, the employer-sponsor must also offer a traditional 401(k) plan.
Income Limits: Importantly, there are no reported income limitations on Roth 401(k) contributions; any employee can contribute, regardless of their reported gross income, to a Roth 401(k) account. However, with a regular Roth IRA, contributions can be phased-out based on the owner’s reported gross income for the year.
Contribution Limits: Roth 401(k) contributions are not subject to the Roth IRA maximum contribution limits of $6,000 for 2019, plus the $1,000 ‘catch-up’ contribution for those age 50 years and older. Instead, Roth 401(k) contributions, and any pre-tax contributions within a plan, are subject to the much higher limit of $19,000 plus a $6,000 ‘catch-up’ contribution for employees age 50 and older.
Combined Annual Account Limits: Note, though, that the Roth 401(k) contribution and pre-tax contributions to a traditional 401(k) account are combined when calculating the participant’s elective deferral limit for the calendar year. The maximum amount that a participant and his/her employer can allocate to a 401(k) plan is $56,000, or $62,000 if the participant is age 50 years or older in 2019. Example: Robert earns $100,000 a year. Robert is under age 50. Robert contributes the full $19,000 to his traditional 401(k) account. Robert’s employer matches 3% of his salary. Accordingly, Robert’s employer contributes another $3,000 to his traditional 401(k) account. The maximum amount that Robert can contribute to the after-tax portion of the qualified plan, i.e. the Roth 401(k) account, is $34,000: $56,000 less $22,000 [$19,000 (traditional 401(k)) + $3,000 (employer match) = $34,000.]. If Robert does not receive any employer match, he will be able to contribute the full $37,000 amount into his after-tax Roth 401(k) plan account.
“Doubling Up:” An individual can potentially contribute the maximum amount to both a Roth 401(k) and a Roth IRA at the same time. Example: Sarah can make salary deferral contributions of her compensation, up to $19,000 in 2019, to a Roth 401(k). An additional $6,000 as a contribution is allowed if Sarah is at least age 50 by the end of 2019. Sarah can also contribute up to $6,000 plus an additional ‘catch-up’ contribution of $1,000 by the end of the calendar year to her Roth IRA. This means that Sarah’s total Roth contributions for 2019 can be as much as $24,000 to her Roth 401(k) account [$19,000+ $6,000] and an additional $7,000 to her Roth IRA [$6,000 + $1,000], or $31,000 in total Roth contributions for 2019.
Roth IRA MAGI Limits: The only limitation that Sarah might face is the modified adjust gross income (MAGI) constraints to Sarah’s eligibility to make a Roth IRA contribution. Those limits for 2019 are a phase-out of her Roth IRA contribution if Sarah is married and filed jointly with her spouse, and their modified adjusted gross income ranges from $193,000 to $203,000 or $122,000 to $137,000 if Sarah is single. However, there is no MAGI income limitation or ‘phase-out’ for contributions to Sarah’s Roth 401(k) account.
Roth IRA and Plan Participation: Contributions to a Roth IRA are not affected by the owner’s additional participation in an employer-sponsored retirement plan, because Roth IRA contributions are never tax deductible. It is a different rule if the employee participates in a qualified plan, and the participant wants to contribute to a traditional IRA.
5-Year Holding Obligation: Roth 401(k) distributions are qualified if they are made after a 5-taxable (calendar) year holding period, and the distribution is (i) made on or after the date the participant attains age 59 ½; and (ii) is due either to the participant’s death or the participant’s disability. Like Roth IRAs, qualified distributions from Roth 401(k) accounts are not includable in the participant’s gross income. While the 5-year holding period runs from the date of the first contribution is made to the designated Roth 401(k) account, this 5-year ‘holding period’ is plan specific, and it does not benefit from any holding period under another Roth 401(k) plan. With a Roth IRA, the 5-year ‘holding period’ starts to run with any contribution made to any Roth IRA.
Loans and Hardship Distributions: Roth 401(k) sponsors can also offer loans and hardship distributions under the same rules that are applicable to a traditional 401(k) account.
In-Service Distributions: Traditional 401(K) contributions are subject to the normal pre-tax distributions rules. Consequently, a distribution of Roth contributions cannot occur until the participant dies, terminates service, becomes disabled, attains age 59 ½, or upon termination of the plan itself. After-tax distributions from a Roth 401(k) can be distributed at any time. As a result, qualified plans can permit in-service distributions of after-tax Roth contributions to the participant, which seems to open up the ability to do a major-‘backdoor’ Roth IRA rollover.
Maximum Account Additions: After-tax Roth 401(k) contributions are only subject to the annual IRC 415 limit of a maximum account contribution of $55,000. This limit looks at all contributions (both participant and employer) to the qualified plan account for the applicable ‘testing’ period. This is much higher than traditional 401(k) contributions, which are capped at the lower pre-tax deferral limit of $19,000 (plus the $6,000 ‘catch-up’ contribution for participants age 50 or older.) As noted earlier, when looking at this lower pre-tax limit, Roth 401(k) contributions are aggregated with other pre-tax salary deferrals.
Testing: The different contributions for Roth 401(k) accounts are also subject to non-discrimination testing rules. Since Roth 401(k) contributions are included with other pre-tax contributions, they are ‘tested’ together in the average deferral percentage (ADP) discrimination ‘test.’ With after-tax contributions, they are tested with employer matching contributions (what is called the average contribution percentage (ACP) discrimination ‘test.’ While both of these tests use the same formula, it is usually much easier for a plan to pass the ADP ‘test.’
Timing of Deposits: One administrative distinction between regular contributions and after-tax Roth contributions deals with deposits. All employee after-tax contributions are fully vested when they are made. Therefore, these contributions must be deposited more frequently from other employer contributions to the participant’s account. Department of Labor guidelines provide that these vested contributions should be deposited into the plan as soon as reasonably possible, but in no event later than the 15th day after the close of the month. This is not a safe harbor rule for plan sponsors, however, and the Department of Labor can still impose a late deposit penalty even if this deposit deadline is met.
Conclusion: Roth 401(k) qualified plan contributions can be an important tool in saving for retirement. Particularly important is the fact that there are no MAGI limits on the amount that a participant can contribute to the Roth 401(k) account, just the maximum account addition limit for the year, e.g. $55,000 plus another $6,000 if the participant is over the age 50. In addition, the ability to contribute to both a Roth 401(k) account and a Roth IRA in the same year means that a substantial amount of funds (and future tax-free income) can be set-aside in a short period.