In a 2019 study of 3,975 small business 401(k) plans, we found about 71% permit participants to make after-tax Roth 401(k) contributions to their personal account. I think it’s safe to assume this high plan adoption rate is due to participant demand.
Why do 401(k) participants like Roth contributions? They offer a tax-free nest egg at retirement. To earn this benefit, participants pay taxes on Roth contributions in the year they are made – at personal income tax rates. This is different than traditional 401(k) salary deferrals, which are tax-deductible in the year they are made - and then tax-deferred until withdrawal.
While Roth 401(k) contributions are popular, they are not for everybody. Because they are taxed upfront, participants are often forced to contribute less - reducing the earnings power over time. Further, participants that expect lower tax rates in retirement are probably better off making traditional pre-tax salary deferrals.
If you are a 401(k) fiduciary, I think now is a great time to consider adding Roth 401(k) contributions to your plan. Personal income tax rates at historic lows, making Roth contributions more affordable than ever. You can use this FAQ to help decide if Roth contributions are right for your plan.
Generally, 401(k) participants that expect their tax rate to be higher in retirement than it is today are the best candidates for Roth contributions. The ideal candidate is a young worker that expects their income to climb throughout their career and a large – otherwise taxable – nest egg at retirement.
However, high earners with taxable investments can also benefit from Roth contributions. Unlike Roth IRA contributions, they have no income restrictions. That means high earners can build a large tax-free account over time to hedge against their taxable investments.
That said, nobody has a crystal ball regarding future tax rates. 401(k) participants at all income levels choose to make Roth contributions to reduce their taxable income in retirement.
When a 401(k) plan includes a Roth feature, any participant eligible to make traditional deferrals can make Roth contributions.
Roth contributions are subject to the same IRC Section 402(g) limit that applies to traditional salary deferrals. When applying this limit, Roth and traditional deferrals are combined. The 402(g) limit is adjusted annually for inflation. For 2021, it is $19,500, plus an additional $6,500 for 401(k) plans that allow catch-up contributions.
Because Roth contributions are made with after-tax dollars, they are never taxable at withdrawal. Their earnings can also be withdrawn tax-free when they’re part of a qualified distribution. A qualified distribution is one that occurs at least five years after the year of the participant’s first Roth deferral and is made:
When Roth contributions are withdrawn as part of a non-qualified distribution, their earnings are taxable at personal income tax rates and may be subject to a 10% early withdrawal penalty if the participant is under age 59 ½.
An in-plan Roth rollover, also called an in-plan Roth conversion, is a reclassification of non-Roth 401(k) funds to Roth funds. Any 401(k) plan that includes a Roth feature can permit in-plan Roth rollovers. 401(k) participants can convert any vested balance, including earnings, to Roth funds.
When a 401(k) participant makes an in-plan Roth rollover, they must report the rollover amount as taxable income for the year of the conversion and pay the tax due. However, these rollovers are not subject to the 10% early withdrawal penalty or mandatory income tax withholding.
Participants are most likely to make in-plan Roth rollovers in tax years where their income is low or their non-Roth account balance has dropped in value.
No. While Roth IRA contributions are not subject to IRS Required Minimum Distribution (RMD) rules until the death of the IRA owner, a RMD of Roth 401(k) contributions must commence the April 1 of the year following the later of:
5% owners of the 401(k) plan sponsor must start RMDs by April 1 of the year following the year they turn 72 (70 ½ if they reached 70 ½ by January 1, 2020).
However, an RMD of Roth 401(k) contributions can be avoided by rolling their amount to a Roth IRA prior to the RMD deadline.
Unfortunately, it can be tough for 401(k) participants to decide whether Roth 401(k) contributions are the right choice for them. The two key deciding factors – future income and tax rates – just aren’t predictable.
However, 401(k) fiduciaries should consider adding a Roth feature to their plan to give participants the chance to reduce their taxes in retirement. Now is a particularly good time for this analysis given historically low personal income tax rates.
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