Roth 401(k) Rules

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If your employer has a 401(k) plan available for you to participate in, you may also have a Roth 401(k) option available as a part of the plan. (We’re referring to 401(k) plans by name here, but unless noted the rules we’re discussing also apply to other Qualified Retirement Plans (QRPs) such as 403(b) or 457 plans.)  Roth 401(k) plans are not required when a 401(k) plan is offered, but many employers offer this option these days.

The Roth 401(k) option, also known as a Designated Roth Account or DRAC, first became available with the passage of the Economic Growth and Tax Relief Reconciliation Act (EGTRRA) of 2001, with the first accounts available effective January 1, 2006.  The Roth 401(k) was designed to provide similar features present in a Roth IRA to the employer-provided 401(k)-type plans.

Similar to traditional 401(k)

Certain features of the Roth 401(k) are similar to the traditional 401(k) plan – since the Roth 401(k) is just an extension of the traditional 401(k), in practice.  For example, the employee-participant has the option to elect to defer a portion of her income into the account, and the employer may provide matching contributions based upon the elected deferrals.

The deferred funds are held in a separate account, and the funds invested in selected investment options.  While the funds are in the plan (before distribution) the growth of the funds occurs without taxation.  Upon reaching retirement age (59½ years of age, usually), the funds can be distributed without penalty to the employee-participant.

Funds can also be rolled over into another employer’s plan or a like-ruled IRA (Roth IRA) without tax or penalty.  If the funds remain in the Roth 401(k) plan and the employee-participant has reached age 70½ years of age, and is no longer employed by the plan sponsor (or is still employed and is a 5% or greater owner), the employee-participant must begin taking Required Minimum Distributions from the plan.

Different from traditional 401(k)

Some very important features about the Roth 401(k) are different from the traditional 401(k), but very similar to features of the Roth IRA.  If not, what’s the point of the separate account, right?

First of all, unlike the traditional 401(k), funds deferred into the Roth 401(k) plan are subject to ordinary income tax.Once contributed, growth in the account is tax-deferred – and if taken out after age 59½, the distributions are not subject to income tax.  This is the same treatment that funds contributed to a Roth IRA receive.

When the employer provides matching funds, those funds are contributed to a traditional 401(k) account rather than the Roth 401(k) account.  Vesting rules apply just like with the traditional 401(k) plan, and these only apply to the matching funds.

In addition, when money has been contributed to the Roth 401(k) plan, in order for the distributions to be fully tax-free, the account must have been established at least five years prior to the distribution, and the account owner must be at least 59½ years of age.

Combined Rules

In total, the employee-participant’s contributions for any tax year to ALL 401(k) plans, traditional or Roth, for all employers, cannot exceed the annual deferral limit – which is $17,500 for 2014, plus a $5,500 catch-up for folks who are over age 50.

Rollovers from the plan to an outside plan (Roth IRA or another employer’s Roth 401(k) plan) are generally not allowed until the employee has ceased employment with the plan sponsor.

Although the traditional and Roth 401(k) plans are likely reported on the same statement to the employee-participant, they are always kept in separate accounts, totally segregated from one another.  This simplifies the application of future tax treatment of the funds in the two types of accounts.  When you have deferred funds into the Roth 401(k) account this action is irreversible – in other words, you cannot move the funds into your traditional account or take them in cash after you’ve deferred into the Roth 401(k) without consequences.

It is possible for the employer to allow in-service rollovers (conversions) from the traditional 401(k) to the Roth 401(k) account – paying ordinary income tax on the converted funds in the tax year of the conversion.  These conversions are an allowed, non-penalized distribution from the 401(k) plan.