Roth 401(k) Plans Have New Appeal for Employers

Kirsch CPA Group

Aug 29, 2024

The traditional 401(k) plan is the most popular qualified retirement plan in the United States. As of March 31, 2024, Americans held $7.8 trillion dollars in 401(k) plans (out of a total $11.1 trillion invested in qualified retirement plans), according to the Investment Company Institute. In fact, your organization probably offers a 401(k) plan to employees.

There’s plenty to like about traditional 401(k) plans. However, distributions from these plans are generally taxable. In comparison, Roth 401(k) plans offer tax benefits similar to those of Roth IRAs, which may appeal to certain employees. So, your organization might want to add a Roth 401(k) plan to your employee benefits menu.

Reviewing Traditional 401(k)s

The 401(k) plan has endured for decades in part because its savings process is relatively simple. Participating employees make contributions to their accounts on a pretax basis through payroll withholding. These contributions are invested in securities — typically, mutual funds — and ideally grow in value on a tax-deferred basis over time. Tax law allows generous limits on annual contributions. In 2024, most participants may contribute up to $23,000, and those age 50 and older are allowed to contribute an additional $7,500 as a “catch-up contribution.” In addition, employers may provide “matching contributions” based on a percentage of an employee’s salary, which also grow tax-deferred in employee accounts.

Finally, when plan participants who are age 59½ or older take distributions, the amounts are taxed at their ordinary income rates. A 10% tax penalty applies to withdrawals made before 59½ unless a special exception applies. Whether plan participants are still working for your organization or not, they must begin taking required minimum distributions (RMDs) from their 401(k) plans after reaching age 73 if they were born between January 1, 1951, and December 31, 1956. Those born between January 1, 1957, and December 31, 1959, must begin taking distributions at age 74. And those born on January 1, 1960, or later must begin taking distributions at age 75.

Traditional 401(k) plans can also feature nontax advantages. For example, they may permit participants to borrow from their accounts, within certain limits, if they experience severe financial hardship or need money to purchase a home, pay for educational costs or cover unexpected medical expenses.

How Roths Are Different

The Roth 401(k) plan, which was introduced in 2006, combines elements of traditional 401(k)s and Roth IRAs. The contribution limits that apply to traditional 401(k) plans also apply to Roth 401(k) plans. If an employer offers both plans, participating employees can split their contributions between the two types of accounts — so long as contributions don’t exceed overall annual limits. Employers can make matching contributions to Roth 401(k) accounts as well. Finally, Roth 401(k) plans feature some of the same nontax benefits — convenience, the ability to borrow from an account and a variety of investment options — as traditional 401(k) plans.

The key difference between traditional 401(k) plans and Roth 401(k) plans lies in the tax treatment of contributions. Roth 401(k) plan contributions are made — like Roth IRAs — with after-tax dollars, which then grow on a tax-deferred basis. The payoff for funding Roth 401(k) plans with after-tax dollars comes at the back end. As with Roth IRAs, distributions from Roth 401(k) plans that have existed for at least five years are completely tax-free if taken after age 59½.

Although they share their tax treatment, Roth 401(k) plans have an edge over Roth IRA plans. The ability to contribute to a Roth IRA is phased out if an account holder’s annual modified adjusted gross income (MAGI) exceeds an annual threshold. For 2024, the phaseout for single filers occurs between $146,000 and $161,000, and between $230,000 to $240,000 for joint filers. But there’s no such restriction for Roth 401(k) plans.

Important Tax Law Provisions

Two tax laws — the Setting Every Community Up for Retirement Enhancement (SECURE) Act and the follow-up SECURE 2.0 Act — include provisions that make Roth 401(k) plans more attractive for employees. Notable changes affect:

Matching contributions. Previously, employer matching contributions were required to be paid to a participant’s taxable account, generally a traditional 401(k) plan. Beginning in 2024, participants can elect to have matching contributions made to their Roth 401(k) accounts. These matching contributions must reflect tax withholding.

RMDs. Previously, lifetime RMDs from Roth 401(k) plans were mandatory. This necessity has been eliminated, beginning in 2024. So participants can leave funds in their Roth 401(k) accounts if they don’t need the money.

Catch-up contributions. Participants age 50 or older eventually will be required to contribute catch-up contributions to their Roth 401(k) accounts if they earn more than $145,000 in the previous year. This change was initially scheduled to take effect in 2024, but the IRS postponed it to 2026 to allow employers time to prepare for the new rules.

More Employers Adopt Them

Almost 90% of employers now offer the Roth 401(k) plan option, as opposed to only 58% in 2013, according to a CNBC survey. So, if you don’t already, you may want to consider doing so — especially if you have employees age 50 and older who make more than $145,000 annually. Kirsch CPA Group can help you determine the best course.

Schedule an appointment to learn how we can support you