More than one third of employers offer ROTH 401(k) contributions as an option in their 401(k) plans, according to a recent AON Hewitt survey, and an additional 38% of those remaining indicate that they will add them in 2011. After languishing for years, ROTH contributions have taken off at least partly because of 2010 changes in the US tax rules. Plan sponsors should consider the pros and cons of this option.
What are ROTH 401(k)s?
ROTH 401(k) accounts are similar to ROTH IRAs. Contributions are made on an after-tax basis and provided they are kept in the plan or IRA for a prescribed period of time, no amount, including any appreciation and earnings, is subject to income tax on distribution. However, ROTH IRA contribution limits are lower than ROTH 401(k) limits, and ROTH IRA contributions phase out completely at higher income levels (though conversions may circumvent these rules). ROTH 401(k) contributions reduce the maximum pre-tax deferrals otherwise permitted to be made by employees ($16,500 in 2011, or $22,000 if the employee is 50 or older) dollar for dollar and are subject to the same distribution restrictions as pre-tax deferrals.
New Conversion Option
Under current law, distributions from qualified plans can be rolled into ROTH IRAs and traditional IRAs can be converted to ROTH IRAs regardless of income level. As a result of a law enacted in 2010, participants in 401(k) plans were given a similar right to convert their plan accounts into ROTH 401(k) accounts without taking a distribution and without regard to their income levels. Conversion is a taxable event, but it permits post-conversion appreciation and earnings to escape tax. 401(k) conversions can greatly increase the amounts eligible for ROTH tax treatment.
Plan participants are now permitted to convert existing pre-tax plan accounts, including amounts representing employer contributions, to ROTH accounts, provided that their plan permits conversions and subject to some important conditions.
- IRS guidance permits conversions only if the amount could otherwise be paid to the participant currently as a distribution. This means that pre-tax contributions and employer 401(k) safe harbor contributions are permitted to be converted by an active participant only at or after age 59 ½. However, employer profit sharing contributions and rollover contributions are not subject to this restriction, and plans may be amended to permit conversions of those accounts without permitting actual withdrawals.
- IRS says that a plan may not permit ROTH conversions unless participants are entitled to make ROTH contributions out of their pay, so a plan may permit ROTH contributions without allowing conversions, but it cannot permit conversions if ROTH contributions are not allowed.
- Finally, IRS has given sponsors until the end of the year in which ROTH conversions are permitted to amend their plans to permit ROTH conversions, though special rules apply to safe harbor plans.
Why add this feature?
- The tax shelter from the ROTH contributions can be substantial, particularly for younger employees who have potentially many years of future earnings and appreciation.
- Employers can match ROTH contributions on the same basis as pre-tax deferrals.
- ROTH accounts and ROTH conversions permit some attractive estate planning strategies.
- Although current tax is payable on any converted amount, asset values may be lower today due to the economy. Further, employees may be paying tax at lower rates than they estimate they will be paying when they take distributions, which is the taxable event for plan accounts that aren’t converted.
- Outside vendors can handle disclosure and administration of ROTH accounts and conversions.
What are the disadvantages?
- Plan sponsors will have to amend their plans, and will have new obligations to explain the differences between the available contributions to employees, the pros and cons of conversions (if they are permitted) and to keep separate records of ROTH accounts while applying specific ordering rules.
- Like pre-tax deferrals, ROTH contributions may be subject to discrimination testing if the 401(k) plan is not a safe harbor plan.
- It is possible that the plan may be amended and new expenses incurred for only a few participants.
- Earnings will be subject to income tax and in many cases an additional 10% penalty if the amounts in ROTH accounts (including converted amounts) are withdrawn prior to the end of a five year holding period or are withdrawn prior to age 59 ½, death or disability.
- Cash is needed to satisfy the tax liability. Unlike a ROTH IRA conversion, a 401(k) plan ROTH conversion can’t be reversed and tax liability is not adjusted if the value of the transferred assets subsequently declines.