3779 / What are the requirements of a Roth 401(k)?

Editor’s Note: Under the SECURE Act 2.0, employees may elect to have employer matching or non-elective contributions made on a Roth basis if the plan offers a Roth option starting with the 2023 tax year.  The IRS has clarified that participants must be given the opportunity to make a Roth election at least once per year (presumably, that election could cover all employer-matching contributions made throughout the year).  The participant must be fully vested to make the Roth election (only allowing fully vested participants to elect Roth matching contributions will not be treated as a discriminatory plan feature).  The plan is still entitled to have a vesting schedule.  Contributions are subject to income tax in the year of contribution but are not subject to employment taxes.  Contributions are reported as in-plan rollovers in Form 1099-R.  A plan may also be permitted to allow only employer Roth contributions without also allowing employee Roth deferrals.¹

A Roth 401(k) feature combines certain advantages of the Roth IRA with the convenience of 401(k) plan elective deferral-style contributions. The IRC states that if a qualified plan trust or a Section 403(b) annuity includes a qualified Roth contribution program, contributions to it that the employee designates to the Roth account, although not being excluded from the employee’s taxable income, will be treated as an elective deferral for plan qualification purposes.² A qualified plan or Section 403(b) plan will not be treated as failing to meet any qualification requirement merely on account of including a qualified Roth contribution program.³

A qualified Roth contribution program means a program under which an employee may elect to make designated Roth contributions in lieu of all or a portion of elective deferrals that the employee is otherwise eligible to make.⁴ For this purpose, a designated Roth contribution is any elective deferral that would otherwise be excludable from the gross income of the employee, but that the employee designates as not being excludable.⁵ Final regulations set forth the following requirements for designated Roth contributions:

(1)  The contribution must be designated irrevocably by the employee at the time of the cash or deferred election as a designated Roth contribution that is being made in lieu of all or a portion of the pre-tax elective contributions the employee is otherwise eligible to make under the plan.

(2)  The contribution must be treated by the employer as includable in the employee’s gross income at the time the employee would have received the amount in cash, if the employee had not made the cash or deferred election (i.e., it must be treated as wages subject to applicable withholding requirements).

(3)  The contribution must be maintained by the plan in a separate account, as provided under additional requirements set forth below.⁶

A plan with a Roth contribution feature must provide for separate accounts for the designated Roth contributions of each employee and any earnings allocable to the account.⁷ Gains, losses, and other credits and charges associated with the Roth accounts must be separately allocated on a reasonable and consistent basis to the designated Roth account and other accounts under the plan. Forfeitures of any accounts may not be reallocated to the designated Roth account. No contributions other than designated Roth contributions and rollover Roth contributions (as described below) may be allocated to the Roth account. The separate accounting requirement applies from the time the designated Roth contribution is made until the designated Roth contribution account is completely distributed.⁸

The maximum amount an employee may claim as a designated Roth contribution is limited to the maximum amount of elective deferrals permitted for the tax year, reduced by the aggregate amount of elective deferrals for the tax year for which no designation is made.⁹ Only one limit can be split between the Roth and salary deferrals of the employee each calendar year.

Designated Roth contributions generally must satisfy the rules applicable to elective deferral contributions. Thus, for example, the nonforfeitability requirements and distribution limitations of Treasury Regulation Sections 1.401(k)-1(c) and (d) must be satisfied for Roth contributions. Designated Roth contributions are treated as elective deferral contributions for purposes of the Actual Deferral Percentage (“ADP”) test.¹⁰

Beginning in 2024,  designated Roth accounts are no longer subject to the minimum distribution requirements of IRC Section 401(a)(9) ( Q 3891 to Q 3909).¹¹ Roth 401(k)s were subject to the RMD rules in 2023, so first-time RMDs for 2023 that were due by April 1, 2024 were still required.  Funds in a Roth IRA are also not subject to the lifetime minimum distribution requirements ( Q 3686).

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Planning Point: Roth IRAs have never been subject to minimum distribution requirements.  That means when a Roth IRA is inherited, the beneficiary never has to worry about annual RMDs--because the original owner, by definition, had no required beginning date--so couldn't have died after that date.  While Roth distributions are not taxable on distribution, the new rule gives beneficiaries of inherited accounts freedom to empty the account as they choose within the ten-year distribution window.  It also gives living taxpayers the option of allowing the funds to grow tax-deferred indefinitely.

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A payment or distribution otherwise allowable from a designated Roth account may be rolled over to another designated Roth account of the individual from whose account the payment or distribution was made or to a Roth IRA of the individual.¹² Rollover contributions to a designated Roth account under this provision are not taken into account for purposes of the limit on designated Roth contributions.¹³

The IRC states that any qualified distribution from a designated Roth account is excluded from gross income.¹⁴ A qualified distribution for this purpose is defined in the same manner as for Roth IRAs except that the provision for “qualified special purpose distributions” is disregarded ( Q 3673).¹⁵ The term qualified distribution does not include distributions of excess deferrals (amounts in excess of the IRC Section 402(g) limit) or excess contributions (under IRC Section 401(k)(8)), or any income on them.¹⁶

Nonexclusion period. A payment or distribution from a designated Roth account will not be treated as a qualified distribution if it is made within the five-year nonexclusion period. This period begins with the earlier of (1) the first taxable year for which the individual made a designated Roth contribution to any designated Roth account established for that individual under the same retirement plan, or (2) if a rollover contribution was made to the designated Roth account from another designated Roth account previously established for the individual under another retirement plan, the first taxable year for which the individual made a designated Roth contribution to the previously established account.¹⁷

The IRC states that notwithstanding IRC Section 72, if any excess deferral attributable to a designated Roth contribution is not distributed on or before the first April 15 after the close of the taxable year in which the excess deferral was made, the excess deferral will not be treated as investment in the contract and will be included in gross income for the taxable year in which such excess is distributed.¹⁸ Furthermore, it adds that “Section 72 shall be applied separately with respect to distributions and payments from a designated Roth account and other distributions and payments from the plan.”¹⁹

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Planning Point: Even though designated Roth contributions are not excluded from income when contributed, they are treated as elective deferrals for purposes of IRC Section 402(g). Thus, to the extent total elective deferrals for the year exceed the 402(g) limit for the year, the excess amount can be distributed by April 15 of the year following the year of the excess without adverse tax consequences. However, if the excess deferrals are not distributed by that time, any distribution attributable to an excess deferral that is a designated Roth contribution is includible in gross income (with no exclusion from income for amounts attributable to basis under Section 72) and is not eligible for rollover. If there are any excess deferrals that are designated Roth contributions that are not corrected prior to April 15 of the year following the excess, the first amounts distributed from the designated Roth account are treated as distributions of excess deferrals and earnings until the full amount of those excess deferrals (and attributable earnings) are distributed.²⁰

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