Offering employees a retirement plan is a great incentive for retaining employees and for recruiting new ones. If you don’t already offer a plan for your employees, an available tax credit may make it something worth considering. If your business does sponsor a 401(k) plan, you might someday consider adding designated Roth contributions. Here are some factors to explore when deciding whether such a feature would make sense for your company and its employees.
Roth contributions differ from other elective deferrals in two key tax respects. First, they’re irrevocably designated to be made on an after-tax basis, rather than pretax. Second, if all applicable requirements are met and the distribution constitutes a “qualified distribution,” the earnings won’t be subject to federal income tax when distributed.
To be qualified, a distribution generally must occur after a five-year waiting period, as well as after the participant reaches age 59½, becomes disabled or dies. Because of the different tax treatment, plans must maintain separate accounts for designated Roth contributions.
Pluses and minuses
The Roth option gives participants an opportunity to hedge against the possibility that their income tax rates will be higher in retirement. However, if tax rates fall or participants are in lower tax brackets during retirement, Roth contributions may provide less after-tax retirement income than comparable pretax contributions. The result could also be worse than that of ordinary elective deferrals if Roth amounts aren’t held long enough to make distributions tax-free.
Nonetheless, if your business employs a substantial number of relatively highly paid employees, a Roth 401(k) component may be well-appreciated. This is because participants can make much larger designated Roth 401(k) contributions than they can for a Roth IRA — in 2020 and 2021, $19,500 for designated Roth 401(k) versus $6,000 for Roth IRA.
Catch-up contributions for individuals 50 or older are also considerably higher for designated Roth 401(k) contributions — in 2020 and 2021, $6,500 for designated Roth 401(k)s versus $1,000 for Roth IRAs. And higher-paid participants who are ineligible to make Roth IRA contributions because of the income cap on eligibility could make designated Roth contributions to your plan.
Yet participants will need to know what they’re getting into. They’ll have to consider:
- Current and future tax rates,
- Various investment alternatives,
- The risk of needing a distribution before they qualify for tax-free treatment of earnings (which would trigger taxation of those earnings), and
- Loss of some rollover options.
For plan sponsors, the separate accounting required for Roth contributions may raise plan costs and increase the risk of error. (One common mistake: treating elected contributions as pretax when the participant elected Roth contributions, or vice versa.)
And because Roth contributions are treated as elective deferrals for other purposes — including nondiscrimination requirements, vesting rules and distribution restrictions — plan administration and communication will be more complex.
Not for everyone
Before adding Roth contributions to your 401(k), be sure participants are adequately engaged and savvy, and will derive enough benefit, to make it worth the risks and burdens. We can assist you in deciding whether this would be an appropriate move for your business.
Deanna A. Olton, CPA, is a Co-Director of our Business & Tax Advisory Group. She can be reached at email@example.com.