Roth 401(k) and 403(b) Plans
Presented by Gerard Longo, AIFA®, CPFA®:
Since their creation several years ago, Roth 401(k) and 403(b) plans have become increasingly popular options for employees to save for retirement. Like their counterparts—traditional pretax 401(k) and 403(b) plans—they are established by an employer and allow eligible employees to save for retirement.
Roth 401(k) and 403(b) plans, however, differ dramatically in terms of tax planning. As is the case with the Roth IRA, contributions are made to Roth 401(k)s and 403(b)s with after-tax deferrals. The after-tax contributions grow tax free, and with a qualifying event, the distribution is tax free.
Example: John is employed by a company offering a Roth 401(k). He earns $40,000 annually. If John decides to defer 10 percent of his pay into the plan, $4,000 will be taken from his pay, but John will still owe taxes on the full $40,000 annual salary. Conversely, if John were to defer 10 percent of his pay, or $4,000, into a traditional 401(k), his taxable income would drop to $36,000.
Roth 401(k) and 403(b) Contributions in General
Employee. Employees may elect to defer 100 percent of their salary—not to exceed $22,500—into a Roth 401(k) or 403(b) for 2023. Employees who are 50 or older may make an additional catch-up contribution of $7,500 for 2023. Unlike the Roth IRA, there are no phase-out limits based on a participant’s adjusted gross income. The total combined contributions to traditional pretax plans and Roth plans for 2023 cannot exceed $22,500 ($30,000 if the participant is 50 or older).
Employer. To encourage employee participation, some employers offer to match employee deferrals under a specific formula. For instance, an employer may match 50 cents of every dollar deferred by the employee, not to exceed 10 percent of the employee’s salary. The employer also can make discretionary contributions in terms of profit sharing.
It’s important to note that with Roth 401(k)s and 403(b)s, only employee deferrals can be deposited into the accounts. If the employer decides to offer a match (or profit sharing), these contributions must be directed into a traditional pretax plan. In addition, the combined contributions to an employee’s account for 2023 (or accounts, if the employer offers more than one type of defined contribution plan) cannot be more than the lesser amount of either 100 percent of that employee’s compensation or $66,000 (excluding catch-up contributions). Further, the maximum tax-deductible employer contribution is limited to 25 percent of the total compensation of all employees covered under the plan.
Eligibility for Setting Up a Roth 401(k) and 403(b) Plan
All organizations—except governmental entities—are eligible to set up a Roth 401(k) plan, while Roth 403(b) plans can be offered by certain religious, public education, and tax-exempt organizations. These plans may be particularly attractive to employers who:
- Are willing to run a traditional pretax plan as well
- Have more than 25 employees
- Have a sufficient number of non-highly compensated employees who will defer a portion of their salaries
- Are willing to spend the time and money these plans require for plan design, administration, and communication Pamela Engstrom
Advantages of Roth 401(k) and 403(b) Plans
- Active role. Both plans allow employees to take an active role in saving for their retirement.
- Contribution flexibility. Employers have some flexibility in deciding if and how much to contribute. An employer can match all or a portion of the employees’ deferrals.
- Tax advantages. Future tax planning strategies can be considered by deferring contributions into a Roth 401(k) and 403(b). Contributions by the employee accumulate tax deferred, and upon qualified distribution, they are tax free.
- Ease in saving for retirement. Employees are not required to defer into the plan; however, if they do, they can change the amount of their deferral or even stop contributing altogether. Because employees make their deferrals through payroll deductions, they may find it easier to save. The money is “out of sight, out of mind.”
Potential Ways to Access Funds
- Loans. Employers may structure 401(k)s and 403(b)s to offer loan privileges, allowing employees to borrow up to 50 percent of their vested balance (not to exceed $50,000). (Reminder: All loans are required to bear a reasonable rate of interest and must not be offered in a discriminatory fashion.)
- Hardship. Employers can also have provisions for hardship distributions because of education, medical, or funeral expenses; hurricane relief; purchase of and repairs to a primary residence; and rent or mortgage payments that will prevent eviction or foreclosure of the participant’s primary residence. (Some restrictions apply for hardship distributions.)
Employees who reach age 50 (or are older than 50) before year-end are eligible to make a catch-up contribution. For plan year 2023, the catch-up contribution amount is $7,500.
Employees contributing to 403(b) plans who have 15 or more years of service with a public school, hospital, home health service, health and welfare agency, or church may be eligible for an additional catch-up contribution.
Drawbacks of Roth 401(k) and 403(b) Plans
- The employer needs professional assistance to establish and administer the plan.
- Like other qualified plans, a 401(k) plan is subject to reporting and disclosure requirements under the Employee Retirement Income Security Act (ERISA).
- Roth plans are not as advantageous as traditional pretax plans for participants who have high fluctuations in income or family incomes that fall below $50,000 and qualify for child tax credits.
- As with traditional 401(k) and ERISA-qualified 403(b) plans, ACP/ADP and top-heavy testing are required.
- Unless it meets safe harbor nondiscrimination requirements, a 401(k) plan is subject to the top-heavy requirements of the IRS Code. A plan is considered to be top-heavy if (as of the determination date) the total sum of the accounts of all key employees (generally the owners and officers of the business) exceeds 60 percent of the total of all employees’ accounts. If the plan is top-heavy, the employer must make a minimum contribution of 3 percent of pay to the accounts of all non-key employees. In addition, the plan must meet specific vesting requirements.
Tax Comparison Between Traditional Pretax and Roth 401(k) and 403(b) Plans
|Participant is older than 50; assumes an 8% annual return compounded annually over 20 years, based on an income tax rate of 28%||Pretax plans||Roth plans|
|Total amount available to invest*||$26,000||$26,000|
|Federal tax paid at time of contribution||$0||$7,280|
|Actual contribution amount made to plan||$26,000||$18,720|
|Account balance at time of distribution||$121,185||$87,253|
|Federal tax rate at time of distribution||Net proceeds|
*Assumes an extra $6,500 catch-up contribution for clients 50 and older.
Income Tax for the Employer
If a business contributes via a match or profit sharing to the Roth 401(k) or 403(b) plan, it can deduct these contributions up to 25 percent of the total compensation of all participants. When calculating the maximum tax-deductible contribution, the maximum compensation base that can be used for any one plan participant is $330,000 in 2023.
In addition to being subject to current income tax, employee deferrals are subject to social security and federal unemployment payroll taxes. Elective deferrals—but not nonelective employer contributions—are subject to payroll taxes under the Federal Insurance Contributions Act, Federal Unemployment Tax Act, and Railroad Retirement Act.
- Qualifying distributions. In order for a participant to receive a qualifying distribution from a Roth 401(k) or 403(b), two events must take place. First, it must be five years from the date of the participant’s first contribution. Second, the participant must turn age 59 ½, become separated from service, become disabled, or die, or the plan must be terminated.
- Required minimum distributions (RMDs). Unlike Roth IRAs, participants in employer-sponsored Roth 401(k) or 403(b) plans are required to take RMDs once they have reached age 72, unless the participant owns 5 percent or less of the company and is still working there.
Please note: There are no restrictions for moving the balance in a Roth 401(k) or 403(b) into a Roth IRA prior to age 72 to avoid having to take any RMDs.
Roth 401(k) and 403(b) plans are great savings opportunities for many people, not just for highly compensated employees. For individuals who expect to be in a higher income tax bracket at retirement, have a longer time frame until retirement, or feel skeptical about the future of the government’s support programs, these plans can put you another step ahead in supporting your desired retirement lifestyle.
Commonwealth Financial Network® does not provide tax or legal advice. Please contact your tax or legal professional regarding your individual situation.
Gerard Longo is a financial advisor located at Global Wealth Advisors 2400 Ansys Drive, Suite 102, Canonsburg, PA 15317. He offers advisory services through Commonwealth Financial Network®, Member FINRA / SIPC, a Registered Investment Adviser. Financial planning services offered through Global Wealth Advisors, LLC are separate and unrelated to Commonwealth. Gerard can be reached at (412) 914-8292 or at firstname.lastname@example.org.
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