Many companies have been forced to reconsider their health care benefits lately. Why not do the same for your retirement benefits? One intriguing option that’s gaining in popularity takes the well-known 401(k) plan and plugs in some key features of a Roth IRA. Not surprisingly, it’s called a Roth 401(k).
Recognizing the differences
Many prospective and current employees may benefit from a Roth 401(k) because, like a Roth IRA, it offers tax-free withdrawals as long as contributions are made after-tax.
But a Roth 401(k) is an add-on to a traditional 401(k). Your plan still must also allow for pretax elective contributions. Employer matching and profit-sharing contributions can be made only to the traditional 401(k) accounts. Participants typically 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.
Adding a Roth 401(k) to your retirement plan doesn’t increase the total amount that employees can contribute. Contribution limits are the same for traditional and Roth 401(k) contributions, or the two combined. Roth 401(k) contributions, like employees’ traditional 401(k) contributions, are always 100% vested.
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 hardships.
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 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.
In addition, the distribution must have a qualified purpose. This means it must be made after the participant reaches age 59½ or because of his or her disability or death, if earlier.
Answering tax 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 predicting the future isn’t easy, 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.
When it comes to contribution limits, married couples filing jointly with adjusted gross incomes (AGIs) exceeding $188,000 per year or singles with AGIs exceeding $127,000 can’t contribute to a Roth IRA, and taxpayers with AGIs nearing those amounts are subject to a contribution phaseout. There are no AGI limits on Roth 401(k) contributions.
Roth 401(k)s also permit much higher contributions than do Roth IRAs. For 2013, the limits are $17,500 vs. $5,500, respectively ($23,000 vs. $6,500 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. On a qualifying event, participants can roll over a Roth 401(k) into a Roth IRA to eliminate RMDs.
As mentioned, Roth 401(k)s seem to be catching on. According to survey data released by Fidelity Investments earlier this year, four out of 10 employers now offer a Roth 401(k) option and 6.3% of participants were saving via this option (as of the end of first quarter 2013) — that’s up from 4.2% four years ago.