Roth Contributions - Features - Pros and Cons

Tip of the Day

By Stephanie Reagan

sreagan@sunlin.biz

Roth Contributions Analysis

Roth Features

  • The Roth feature is optional under 401(k) and 403(b) plans (and Governmental 457 plans).
  • Roth is available to employees eligible to make elective contributions.
  • Roth 2015 maximum dollar limits (combined with 401(k) or 403(b) elective deferrals): $18,000 with catch-up of $6,000. After 2015, the dollar limits may increase for cost of living adjustments.
  • Roth contributions are treated by the employer as wages subject to withholding in the year of deferral.
  • Roth contributions and earnings are maintained in a separate account.

  • A Roth account may be rolled over to another Roth 401(k) or 403(b) plan or to a Roth IRA.

  • 401(k) and 403(b) elective contribution distribution rules apply to Roth plan distributions, i.e., permitted upon termination of employment, death, disability, retirement, attainment of age 59 ½ or hardship.

  • Distributions of Roth deferral contributions will not be taxed.

  • Distributions of the Roth account earnings will not be taxed if the distribution is a "qualified" distribution.

A "qualified" distribution is one that is made after a participant has attained age 59 1/2 or is made on account of your death or disability. In order to be a "qualified" distribution, the distribution cannot be made prior to the expiration of a 5-year participation period. The 5-year participation period is the 5-year period beginning on the calendar year in which the participant first made a Roth 401(k) deferral to the plan (or to another 401(k) plan or 403(b) plan if such amount was rolled over into this Plan) and ending on the last day of the calendar year that is 5 years later.

For example, if a participant made his or her first Roth 401(k) deferral under the plan on December 2, 2015, the 5-year participation period will end after December 31, 2019. It is not necessary that an employee participant make a Roth 401(k) deferral in each of the five years.

 Pros

  • Roth 401(k) is expected to be most attractive to young workers because they generally will have low income tax for the early years of employment and will have many years of tax-free accumulation of earnings when distributed.

  • It is attractive to high-income workers because they will have access to a savings account that offers tax-free withdrawals of earnings because the Roth 401(k) or 403(b) plan account carries no maximum earnings restrictions as is the case for the Roth IRA.

  • High-income employees are more likely to take the gamble that their tax rates are currently quite low, based on historical data, which improves the chance that rates will be higher for this group come retirement.

  • If the Roth funds are rolled into a Roth IRA upon retirement, there will be no required minimum distribution age of 70 ½.

  • A qualified tax-free Roth 401(k) distribution will not be counted for determining the taxability of Social Security benefits.

  • Rolled-over Roth IRA assets to a Roth 401(k) may be available for loans and may be eligible for ERISA anti-alienation protection.

     Cons

  • Subject to ADP testing, Sections 402(g) and 415 dollar limits (same as pre-tax deferrals)

  • Impact on administrative processes generally provided by recordkeeper

    • Separate accounting for Roth contributions

    • Tracking 5 year aging

    • Tracking combined limits and tax basis

    • Changes to website, enrollment kits, participant statements

    • Corrective distribution elections

    • Rollover elections

    • Tax reporting

    • Hardship distributions

  • Should weigh the cost of losing tax benefits of pre-tax elective contributions vs. tax-free appreciation

  • In a rollover of a plan Roth account to a Roth IRA, the 5-year holding period of the Roth inside of the plan does not tack on to the Roth IRA

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