Designated Roth Accounts or Roth 401k are simply 401k plans that allow employees to designate all or part of their elective deferrals as qualified Roth 401k contributions. Qualified Roth 401k contributions are made on an after-tax basis, just like Roth IRA contributions. This means that employee 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 401k or deductible IRA contributions are). This article discusses qualified Roth 401k contributions.
Caution: 401k sponsors are not required to allow Roth contributions to their plans. But if they do, the 401k plan also can’t be a “Roth only” plan. That is, if the 401k plan allows Roth 401k contributions, then employees must be allowed to make both Roth contributions and pre-tax contributions. SIMPLE 401k and safe-harbor 401k plans can also allow Roth contributions, as can 403b Plans. The rules discussed in here generally apply to Roth 403b accounts as well.
Roth 401k contributions
Technically, an employee makes a Roth 401k contribution by making an elective deferral under the 401k plan, irrevocably designating all or part of that deferral as a Roth 401k contribution. Roth 401k contributions are treated the same as pre-tax 401k elective deferrals for all plan purposes, except that they are included in an employee’s wages for tax purposes at the time of contribution (i.e., Roth 401k contributions are after-tax contributions, where pre-tax 401k contributions are deducted from income before payroll tax). Both types of contribution are subject to Social Security and Medicare tax when earned.
A 401k plan must establish a separate Roth 401k account (designated Roth accounts, or DRACs) to house each employee’s Roth 401k contributions. The Roth 401k account is treated as a “separate contract” under the 401k plan, requiring separate accounting for the Roth contributions, as well as 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 401k 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 the account 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 for designated Roth accounts
Any employee who is eligible to participate in a 401k plan can make Roth contributions, as long as the plan allows Roth contributions. Unlike Roth IRAs, no income restrictions apply to a Roth 401k program. Even highly paid employees who aren’t otherwise eligible to contribute to a Roth IRA can make Roth 401k contributions.
Because Roth contributions to a 401k plan are treated as elective deferrals, careful attention must be paid to the elective deferral limits. In 2018, an employee is allowed to contribute up to $18,500 of his or her compensation to a 401k plan. Participants who are age 50 or older may also make additional “catch-up” contributions of up to $6,000 in 2018.
These limits apply to the total of all elective deferrals (including both pre-tax contributions and after-tax Roth contributions) that an employee makes during the year to any 401k plan, 403b plan, SAR-SEP, or SIMPLE plan, whether or not sponsored by the same employer. SIMPLE plans have a limit of $12,500, while SAR-SEPs have the same limitation as 401k plans. The employee is responsible for making sure the overall limit isn’t exceeded. This can be complicated 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, 2018. Joe has already made $10,000 of elective contributions ($5,000 Roth 401k and $5,000 pre-tax 401k) to his former employer’s plan in 2018. Joe can only contribute an additional $8,500 to his new employer’s Roth or regular 401k plan in 2018 ($14,500 if Joe is age 50 or older).
If an employee contributes too much in any particular year, the employee must withdraw the excess (and the applicable earnings) before April 15 of the following year to avoid adverse tax consequences. If an employee fails to make a timely withdrawal, any excess Roth 401k contributions are tax-free, however, the applicable earnings will be subject to income tax. Both the excess contribution and the earnings will be subject to an early distribution penalty when distributed from the plan within the first 5 years of participation. This distribution (contributions and earnings) will not be eligible for rollover to another employer plan or IRA. A distribution of excess Roth deferrals and applicable earnings cannot be a qualified distribution.
Total annual additions to an employee’s 401k plan account in 2018 – including employer contributions, forfeitures, and employee pretax, Roth, and non-Roth after-tax contributions – can’t exceed $55,000 (plus any allowable catch-up contributions). You must treat all defined contribution plans you maintain (including 401k plans, 403a annuity plans, 403b plans, and SEPs or SAR-SEPs) as a single plan for purposes of calculating the annual additions limit.
Treatment of Roth 401k contributions as elective contributions
Roth 401k contributions are treated as elective deferrals for all 401k plan purposes. That is, except for the tax treatment, they are treated the same as pre-tax 401k contributions.
For example, Roth 401k contributions:
- Can be distributed only for one of the following reasons: severance from employment, age 59½, 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 401k nondiscrimination testing
- Must be distributed starting at age 70½ (or, in some cases, after retirement)
- Can be borrowed (if the plan allows)
- Qualify for the retirement plan “Saver’s Credit”
An employer can match employees’ Roth 401k contributions, pre-tax contributions, or both, but employer contributions are always made on a pre-tax basis, even if they are to match employees’ Roth 401k contributions. Put simply, employer matching contributions, and earnings on those contributions, are not added to an employee’s Roth 401k account, but rather to the employee’s regular 401k. As such, these matching contributions and growth will be subject to federal (and many state) income taxes when distributed from the 401k plan regardless of whether they match an employee’s pre-tax or Roth 401k contributions.
A 401k 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 make matching contributions to traditional 401k plans, many employers match all or part of their employees’ contributions. Employers can also make discretionary profit-sharing contributions to a 401k plan. Special rules apply to SIMPLE 401k plans, safe-harbor 401k plans, and 401k 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.