Designated Roth Accounts (Roth 401(k) or Roth 403(b))

Designated Roth Account

A Designated Roth Account or Roth 401(k) is simply a 401(k) plan that allows employees to designate all or part of their elective deferrals as qualified Roth 401(k) contributions. Qualified Roth 401(k) contributions are made on an after-tax basis, just like Roth IRA contributions. This means that employees’ contributions and earnings are entirely free from federal income tax when distributed from the plan, subject to qualifications. Contributions are not deducted from income (as regular 401(k) or IRA contributions are). This article discusses qualified Roth 401(k) contributions.

Caution: 401(k) sponsors don’t have to allow Roth contributions to their plans. But if they do, the 401(k) plan can’t be a “Roth only” plan. That is, if the 401(k) plan allows Roth contributions then employees must be allowed to make both Roth contributions and pre-tax contributions.  SIMPLE 401(k) and safe-harbor 401(k) plans can also allow Roth contributions, as can 403(b) Plans.  The rules discussed in here generally apply to Roth 403(b) accounts as well.

Roth 401(k) contributions

In general

Technically, an employee makes a Roth 401(k) contribution by making an elective deferral under the 401(k) plan, and then irrevocably designating all or part of that deferral as a Roth 401(k) contribution.  Roth 401(k) contributions are treated the same as pre-tax 401(k) elective deferrals for all plan purposes, except that they’re included in an employee’s wages for tax purposes at the time of contribution (i.e., Roth 401(k) contributions are after-tax contributions).

A 401(k) plan must establish a separate Roth 401(k) account to track each employee’s Roth 401(k) contributions. The Roth 401(k) account is treated as a “separate contract” under the 401(k) plan, requiring separate accounting for the Roth contributions and any gains or losses on those contributions. The taxation of distributions from the Roth account is also determined separately from any other plan dollars.

Even though a Roth 401(k) account is treated as a “separate contract,” the amount a participant can borrow, or withdraw on account of hardship, is determined based on the participant’s combined Roth and non-Roth plan account balances.  In addition, Roth and non-Roth account balances are combined to determine whether a participant’s vested accrued benefit is $5,000 or less, allowing it to be involuntarily cashed-out upon termination of employment. However, the Roth and non-Roth account balances are treated separately when determining whether a cashed-out participant’s vested accrued benefit exceeds $1,000, requiring an automatic rollover to an IRA in some cases.

Eligibility

Any employee who’s eligible to participate in a 401(k) plan can make Roth contributions (assuming the plan allows Roth contributions). Unlike Roth IRAs, no income restrictions apply to a Roth 401(k) program. Even highly paid employees who aren’t eligible to contribute to a Roth IRA can make Roth 401(k) contributions.

Contribution Limits

Because Roth contributions to a 401(k) plan are treated as elective deferrals, careful attention must be paid to the elective deferral limits. In 2009, an employee can’t contribute more than $16,500 of his or her compensation to a 401(k) plan. Participants who are age 50 or older may also make additional “catch-up” contributions of up to $5,500 in 2009.

These limits apply to the aggregate elective deferrals (including both pre-tax contributions and after-tax Roth contributions) that an employee makes during a year to any 401(k) plan, 403(b) plan, SAR-SEP, or SIMPLE plan, whether or not sponsored by the same employer. The employee is responsible for making sure the overall limit isn’t exceeded if he or she participates in plans of more than one employer during a calendar year.

Example(s): Joe begins working for a new employer on July 1, 2009. Joe has already made $10,000 of elective contributions ($5,000 Roth and $5,000 pre-tax) to his former employer’s 403(b) plan in 2009. Joe can only contribute an additional $6,500 to his new employer’s Roth 401(k) plan in 2009 ($12,000 if Joe is age 50 or older).

If an employee contributes too much in any particular year, the employee must withdraw the excess (and applicable earnings) by April 15 of the following year to avoid adverse tax consequences. If an employee fails to do so, the excess Roth 401(k) contributions, which normally would be tax-free, and applicable earnings, will be subject to income tax (and a potential early distribution penalty) when distributed from the plan, and will not be eligible for rollover to another employer plan or IRA. A distribution of excess Roth deferrals and applicable earnings can not be a tax-free qualified distribution.

Total annual additions to an employee’s 401(k) plan account in 2009 – including employer contributions, forfeitures, and employee pretax, Roth, and non-Roth after-tax contributions – can’t exceed $49,000 (plus any allowable catch-up contributions). You must treat all defined contribution plans you maintain (including qualified plans, 403(a) annuity plans, 403(b) plans, and SEPs) as a single plan for purposes of calculating the annual additions limit.

Treatment of Roth 401(k) contributions as elective contributions

Roth 401(k) contributions are treated as elective deferrals for all 401(k) plan purposes. That is, except for the tax treatment, they are treated the same as pre-tax 401(k) contributions.

For example, Roth 401(k) contributions:

• Can be distributed only for one of the following reasons: severance from employment, age 59 ½, disability, hardship, or death (and a hardship distribution will generally trigger a minimum six-month suspension penalty)
• Must be included with pre-tax contributions when performing 401(k) nondiscrimination testing
• Must be distributed starting at age 70 ½ (or, in some cases, after retirement)
• Can be borrowed (if the plan allows)
• Qualify for the retirement plan “Saver’s Credit”

Employer contributions

An employer can match employees’ Roth 401(k) contributions, pre-tax contributions, or both, but employer contributions are always made on a pre-tax basis, even if they match employees’ Roth 401(k) contributions. That is, employer matching contributions, and earnings on those contributions, aren’t added to an employee’s Roth 401(k) account. They will be subject to federal (and most state) income taxes when distributed from the 401(k) plan regardless of whether they match an employee’s pre-tax or Roth 401(k) contributions.

A 401(k) plan can require that an employee have up to 6 years of credited service before the employee is fully vested in employer matching contributions.

While employers aren’t required to contribute to traditional 401(k) plans many employers match all or part of their employees’ contributions. Employer’s can also make discretionary profit-sharing contributions to a 401(k) plan. (Special rules apply to SIMPLE 401(k) plans, safe-harbor 401(k) plans), and 401(k) plans that contain a safe-harbor qualified automatic contribution arrangement (QACA).)

In another post we’ll cover the specifics of distributions from a Designated Roth Account.

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Jim Blankenship, CFP®, EA, is an expert in personal retirement, IRAs, and tax issues, with more than 20 years of experience in the industry.  . Read more from this author