401(k) & Taxation: 10 Things Employers Should Know

Written by Joanna Morrow

Joanna Morrow, Principal and Founder of Employer Benefits & Advice, is an employer consultant and advocate who has worked in the employee benefits industry for over two decades. She works diligently to help employers overcome obstacles in their business by sharing her expertise in Human Resources, Benefits & Compensation, Process Mapping, Risk Management and ERISA/DOL/IRS compliance. She is a licensed life and health insurance professional in the State of Arizona and is an active member of the National Association of Health Underwriters (NAHU).

401(k) & Taxation: 10 Things Employers Should Know

It used to be that setting up a 401K plan was a daunting task but in recent years plan sponsors have evolved and made plans a lot more user friendly. Recent research performed by Willis Towers Watson reported the following statistics:

  • Around 40% of sponsors reduced the number of investment options they offer over the past three years and another 41% plan to do so by 2020.
  • Approximately 25% of employers increased their 4019(k) contribution, either by raising the match they offer to participating employees or through other means.
  • Lastly, 70% of plan sponsors now offer Roth features within their 401(k) plans, an increase from 54% in 2014 and 46% in 2012. Read on to learn more about this newest trend.

1. What is a Roth 401(k)?

A Roth 401(k) combines features of a traditional 401(k) plan with those of a Roth Individual Retirement Account (IRA).

Similar to a traditional 401(k) feature, a Roth 401(k) feature is offered by employers, but like a Roth IRA, contributions are made with after-tax dollars.

2. How does a Roth 401(k) feature compare to a traditional 401(k)?

The primary difference between the two plan features is the way in which contributions are taxed. The contributions made to a traditional 401(k) account reduce the amount of income a participant has to report that year, which results in a smaller tax bill. The participant then pays taxes on those contributions plus all the investment earnings on those contributions upon withdrawal. There is no difference in investment opportunity between the two features.

With a Roth 401(k), participant contributions do not reduce participant taxes in the year the contributions are made, but all of the earnings in that account will be tax-free as long as the account exists. If certain requirements are satisfied, the participant does not pay tax when he or she receives a distribution of the Roth contributions and related earnings.

3. What is the tax treatment on a Roth 401(k)?

In a Roth 401(k), participants pay tax on their 401(k) contributions at the time of deferral. Withdrawals (including the earnings on the Roth contributions) are then tax-free if certain requirements are satisfied.

4. What if we already offer a traditional 401(k)? Do we have to set up a separate plan to offer a Roth 401(k)?

A Roth 401(k) feature is not a separate retirement plan, but a different type of contribution that can be added to an existing 401(k) plan. An employee may contribute to both a Roth 401(k) and a traditional pre-tax 401(k) in the same year in the proportion selected by the employee.

5. Why Should an Employer Consider Offering a Roth 401(k)?

Competitive Advantage

The advantage of the Roth 401(k) to plan sponsors is the ability to offer additional retirement savings options to employees. Companies without a Roth 401(k) feature may want to add this option to remain competitive with other employers that allow Roth 401(k) contributions.

Opportunity to Diversify the Tax Treatment of Investment Savings

In addition, adopting a Roth 401(k) provides your employees with the opportunity to diversify the tax treatment of their retirement savings, since even those individuals who are ineligible for Roth IRAs due to income caps are eligible to contribute to a Roth 401(k).

6. What are the advantages of a Roth 401(k)?

The following are the benefits of a Roth 401(k):

Tax Treatment

Contributions are taxed at the time of deferral, but distributions (including earnings) are tax-free if five years have passed since the participant first started making Roth contributions to the plan and the distribution is made after age 59½ or on account of death or disability. The five-year period begins on the first day of the taxable year during which the participant first started making his or her Roth contributions to the plan.

No Minimum Distribution Requirement

There is no minimum distribution requirement at age 70½ if Roth contributions are rolled over to a Roth IRA prior to that age.

Distribution upon Death

Upon a participant’s death, Roth contributions and earnings may be distributed tax-free to the participant’s beneficiary or estate.

No Income Limitations

Unlike a Roth IRA, there are no income limitations on making Roth 401(k) contributions.

7. What are the disadvantages to a Roth 401(k)?

No Current Year Tax-Savings

No current-year tax savings are associated with Roth 401(k) contributions. With traditional 401(k) contributions, participants receive reduced taxable income in the current year. With Roth 401(k) contributions, participants have to wait for any tax benefit.

Time Requirement

To receive a tax benefit when withdrawing Roth 401(k) contributions and earnings, participants generally have to wait to take a withdrawal until they reach age 59½ and at least five years have passed since they started making Roth 401(k) contributions to the plan.

Accurate Prediction of Tax Savings

To compare the tax savings of pretax 401(k) contributions and Roth contributions, it is hard to predict if one’s tax bracket will be higher or lower in the future.

8. What are some of the rules associated with a Roth 401(k)?

Below are some rules to be mindful of regarding a Roth 401(k):

Contribution Limits

A worker’s combined pretax 401(k) and Roth 401(k) contributions cannot exceed $19,000 ($25,000 for employees 50 years of age and older) in 2019.

Withdrawals

Withdrawals of contributions and earnings are not taxed provided that the account is held for at least five years. Withdrawals are made on account of disability, after death, or on or after attainment of age 59½.

Employer Contributions

Employers may make matching contributions on participants’ Roth 401(k) contributions. Matching contributions accumulate in a separate account that will be taxed as ordinary income at withdrawal.

Early Distributions

Early distributions of Roth 401(k) contributions are generally subject to the same rules as early distributions of pretax 401(k) contributions.

Minimum Distributions

Participants must take minimum distributions beginning the year after they turn 70½.

Roll-Over

The Roth 401(k) balance can be rolled over into a new employer’s Roth 401(k) or into a Roth IRA if an employee leaves his or her job.

Conversion

Employers with a Roth 401(k) feature may decide to allow in-plan conversion rollovers to Roth accounts. An in-plan conversion rollover allows participants with pretax 401(k) contributions to convert those contributions to Roth amounts while keeping their retirement savings in the plan. In-plan conversions are an optional design choice for the plan sponsor, and are not required.

Changes

Once a participant designates his or her contributions as Roth 401(k) contributions, he or she cannot later change those contributions to pre-tax 401(k) contributions.

9. What should employers consider before offering a Roth 401(k)?

When deciding whether to offer a Roth 401(k) feature, plan sponsors should consider the following:

Legislation

The Pension Protection Act of 2006 made the Roth 401(k) a permanent retirement plan option (it was originally set to “sunset” at the end of 2010).

Tracking & Record-Keeping

Roth 401(k) contributions and earnings must be tracked separately than pretax 401(k) contributions, and must be held in separate Roth accounts. Because of the additional plan administration involved with Roth contributions, your plan’s record keeper may charge an additional fee for Roth accounts.

Payroll Administration

The plan sponsor should consider whether its payroll system can accept Roth 401(k) contribution elections and process the deductions.

Employee Education

Because employee contributions have traditionally been made on a pretax basis, employers that incorporate a Roth 401(k) feature should educate their employees about the Roth 401(k)’s tax features.

10. Which employees should consider the Roth 401(k)?

The answer to this question largely depends on what tax bracket a participant is in today, as compared to which tax bracket the participant expects to be in upon retirement. If the participant is early in his or her career, making a fairly modest salary and anticipates being in a higher tax bracket upon retirement, the Roth 401(k) is appealing because the participant is paying taxes on contributions today at the lower rate. Later, he or she will be able to withdraw that money without paying taxes.

High Income Earners

Higher paid participants also can benefit from a Roth 401(k) because they are generally locked out of other savings vehicles such as a Roth IRA that accumulate profits tax-free. The tax-free withdrawals also help highly paid workers manage their tax situation in retirement.

Middle-Aged Workers

For workers in their 40s and 50s, the choice to contribute to a Roth 401(k) may not be as easy. With the Roth, these participants pay taxes up front when they are in a high tax bracket and then withdraw the money when they are in a lower tax bracket.

Income Bracket at Retirement

All in all, those who will be in a lower tax bracket during retirement are probably better off contributing to a pre-tax 401(k). Furthermore, the longer the amount of time before retirement, the greater the tax benefit, since participants are exempting more investment earnings from taxation.

The chart below compares the major facets of a Roth 401(k) and a traditional 401(k).

* The contribution limitation is by individual, rather than by plan. Although permissible to split the annual employee elective contribution between Roth contributions and traditional pre-tax contributions, the combination cannot exceed the deferral limit specified above.

For assistance or questions relevant to setting up a Roth 401(k), contact us at [email protected] or 602-903-4047.