401(k) plans are the most popular form of retirement for businesses. According to this data from the Employee Benefit Research Institute (EBRI), nearly 59% of the U.S. workforce can participate in a 401(k) plan. An increasing number of these plans use automatic enrollment to ensure that employees are saving for retirement and to make it easier for small employers to meet plan requirements. And many entrepreneurs who fly solo have their own 401(k)s to maximize their retirement savings.
Designated Roth account
These are build-ons to a traditional 401(k) plan, which means that you can’t have a designated Roth account unless there is a 401(k) plan that allows it. Contributions to designated Roth accounts are made with after-tax dollars; there is no exclusion from income for contributions. And once the contribution has been made to this account, it cannot be recharacterized later on. However, the key benefit is that contributors build up tax-free retirement income. And, unlike Roth IRAs, there are no income limits on eligibility to make contributions to designated Roth accounts.
The maximum contribution to a designated Roth account depends on the annual limits for 401(k)s. The reason: The annual limits apply to combined contributions to regular 401(k)s and designated Roth accounts. Thus, for 2017, the maximum total contribution is $18,000 ($24,000 for those who will be at least 50 years old by the end of this year).
The contributor can allocate the annual limits in any way he or she desires. For example, a 55 year old can allocate $14,000 as a contribution to the 401(k), which is excludable from gross income, and $10,000 to the designated Roth account. The portion of salary added to the designated Roth account is taxable now.
Where there are matching employer contributions for 401(k)s, no amount can be allocated to a designated Roth account. However, the plan may allow that contributions to the designated Roth account are factored in when figuring matching contributions.
A 401(k) plan may allow for a rollover from another account in the same plan to a designated Roth account—from the regular 401(k) to the designated Roth account. This rollover is actually a conversion that is taxable (except to the extent of any after-tax employee contributions), but it allows future earnings to build up tax free. Even though this type of rollover is taxable, there’s no 10% penalty even if the person is under age 59½.
The in-plan conversion must be a direct transfer, and not a distribution followed by a rollover within 60 days. The conversion can apply to:
- Elective salary deferrals
- Matching contributions
- Nonelective contributions
- After-tax employee contributions
- Amounts rolled into the plan from another plan
- Qualified matching contributions (QMACs)
- Qualified nonelective contributions (QNECs)
Not all plans allow for an in-plan conversion. It’s up to the plan to say which types of amounts can be converted, and how often this type of rollover can be done each year. Plan sponsors do not withhold any income tax on the taxable conversion.
If it is permissible, it is only advisable if the individual has a low-tax year. For example, a business owner with a 401(k) that allows for in-plan conversions to a designated Roth IRA, has a bad year. This may be an ideal time to do a conversion (i.e., pay the tax on the converted funds).
The big unknown that really matters is what the tax rates will be in the near and distant future. Watch for upcoming tax changes that may lower tax rates soon or make other changes impacting in-plan conversions. Of course, any tax cuts made by this Administration could be undone by a future Administration, and impact the rates applicable during a person’s retirement.
Because a designated Roth account is subject to required minimum distributions during the owner’s lifetime, it may be advisable to roll over funds in the designated Roth account to a Roth IRA. This can be done by taking a distribution and depositing it in the Roth IRA account within 60 days or making a direct trustee-to-trustee transfer. Once it’s in the Roth IRA, there are no required minimum distributions (RMDs) during the owner’s lifetime.
A spouse who is the beneficiary of a Roth IRA can roll it over to his/her own Roth IRA and name new beneficiaries. A nonspouse beneficiary of a Roth IRA must take distributions from the account over his/her lifetime; they are not taxable.
If your business has a 401(k) plan which lacks a designated Roth account option, consider adding one. Then it’s up to you to educate employees about the unique rules that apply to this special type of account. If you have a solo 401(k), you can have a designated Roth account and create some tax-free retirement income. All in all, talk with a benefits expert to make sure the plan includes the features that you want for you and your employees.