Business owners who are contributing to a Roth IRA (or are considering if they should) can realize a greater impact with the Roth features in a 401(k) plan.
401(k) plans can allow participants to defer salary as a Roth contribution instead of, or in addition to, traditional pre-tax salary deferral contributions.
In a 401(k) plan, adding the Roth feature allows a participant to defer up to $18,000 (plus another $6,000 if the participant is at least age 50) as a Roth contribution. The limits that apply to employee salary deferral contributions will apply to the total of Roth contributions and traditional salary deferral contributions made by a plan participant. Adding a Roth contribution feature to a plan will not increase how much a participant can defer in total.
By comparison, the 2017 limit for a Roth IRA is $5,500 (plus $1,000 starting at age 50). The Roth IRA limit may be even lower depending on taxable income and filing status. This adjustment doesn’t exist in a 401(k) plan. Having more than one Roth IRA also doesn’t change the total contribution limit per individual.
Similar to IRAs, there are also opportunities for Roth conversions in a 401(k) plan. In-plan Roth conversions may either be an In-Plan Roth Transfer or an In-Plan Roth Rollover.
If a plan permits it, an In-Plan Roth Transfer is made at the election of the participant. Only vested amounts may be transferred to Roth status, and the Plan will specify which money types (pre-tax salary deferral, profit sharing, rollover, etc.) may be transferred. The Plan may put other restrictions on these transfers, such as a minimum transfer amount, or limiting transfers to one or two per year.
An In-Plan Roth Rollover may be allowed when the participant is eligible to receive a distribution that could be taken as a lump sum or rollover. This is generally upon separation from service with the plan sponsor or, if the plan allows in-service distributions, when the participant meets certain age and service criteria. The difference is that the money that would otherwise be paid out of the plan stays in the plan.
In either case, the participant must pay income tax on the amount transferred. This could be an effective tax strategy if the participant has other deductions or losses that will offset this additional taxable income.
Including Roth provisions in a 401(k) plan will complicate plan administration, and therefore could increase administration costs. Whether a plan sponsor decides to implement Roth provisions in a 401(k) plan depends on how valuable the feature is perceived to be in terms of future tax savings for participants.
Regardless of whether in-plan Roth conversions are allowed in a plan, a participant may roll all or part of any lump sum benefit distribution into a Roth IRA. This opportunity applies as well to defined benefit plans that pay lump sums.