QUESTION: Some of our employees have asked for the opportunity to make designated Roth contributions to our 401(k) plan. What factors should we consider when deciding whether that feature makes sense for our plan?
ANSWER: Evaluating the Roth option requires weighing the potential benefits, additional complexity, and risks for participants, as well as the administrative burdens for your plan. As you probably know, Roth contributions differ from other elective deferrals in two key tax respects. First, they are irrevocably designated to be made on an after-tax, rather than on a pre-tax, basis. Second, if all applicable requirements are met and the distribution constitutes a “qualified distribution,” the earnings will not be subject to federal income tax when distributed. (To be “qualified,” a distribution generally must occur after a five-year waiting period and after the participant’s death, disability, or attainment of age 59 ½.) Because of the different tax treatment, plans must maintain separate accounts for designated Roth contributions.
Here are some factors to consider when deciding whether Roth contributions are right for your plan:
Hedge Against Tax-Rate Increases Carries Some Risk. The Roth option gives participants an opportunity to hedge against the possibility that their income tax rate will be higher in retirement. But if tax rates fall or participants are in lower tax brackets during retirement, Roth contributions may actually give them less after-tax retirement income than comparable pre-tax contributions. The result could also be worse than that of ordinary elective deferrals if Roth amounts are not held long enough to make distributions of earnings tax-free.
Opportunity to Exceed Roth IRA Limitations. Participants who might have been eligible to make Roth IRA contributions can get similar tax treatment on much larger designated Roth contributions (in 2020 and 2021, $19,500 for designated Roth versus $6,000 for Roth IRA). Catch-up contributions for individuals 50 or older are also considerably higher for designated Roth contributions (in 2020 and 2021, $6,500 for designated Roth versus $1,000 for Roth IRA). And higher-paid participants who are not eligible to make Roth IRA contributions at all—due to the income cap on Roth IRA eligibility—would be able to make designated Roth contributions to your plan.
Maximizing Benefits in the Plan. Pre-tax and Roth balances don’t have the same buying power at retirement because pre-tax balances are subject to federal income tax upon distribution and Roth balances are not. But the contribution limits for pre-tax elective deferrals and Roth contributions are the same, so a participant who wants to maximize the benefit from the plan at retirement will favor Roth contributions. Participants who make pre-tax contributions may be able to achieve the same result as those who make maximum Roth contributions, but to do it they will need to invest their tax savings outside the plan, and that may be less attractive for multiple reasons (e.g., less convenient, higher fees, less bankruptcy protection).
Automatic Contributions and Roth Conversions. Plans with automatic deferrals can provide that a portion of default deferrals will be treated as designated Roth contributions. And plans offering Roth contributions can offer participants the opportunity to convert pre-tax deferrals to Roth contributions within the plan.
Complexity of the Decision and Communication. Participants deciding whether to make Roth contributions will need to consider current and future tax rates, their investment alternatives, the risk that they will need a distribution before they qualify for the tax-free distribution of earnings (which would trigger taxation of the earnings), and the loss of some rollover options. Plan SPDs and other participant communications will be more complex.
Complexity of Plan Administration. The separate accounting required for Roth contributions may result in higher plan costs and increase the risk of error. (One common mistake is treating elected contributions as pre-tax 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 will be more complex.
Before adding Roth contributions, a plan sponsor should feel comfortable that plan participants can derive enough benefit from the Roth opportunity to make it worth the risks and burdens. For more information, see EBIA’s 401(k) Plans manual at Sections VIII.E (“Roth Contributions”) and XIV.J.1.c (“Qualified Distributions of Designated Roth Contributions”).
Contributing Editors: EBIA Staff.