Roth contributions are taxable when made but their earnings may permanently escape tax if distributed on or after age 59 ½ and after a five year holding period has been satisfied. They are particularly attractive to younger employees who have more years for investment earnings to compound. Around 90% of 401(k) plans now permit participants to make employee deferrals on a Roth basis and a smaller percentage of those plans permit in-plan Roth conversions. Unlike Roth IRA contributions, which are not directly available to high income employees, there is no income-based limit applicable to Roth contributions to an employer plan..
SECURE 2.0 Expended Roth Opportunities for 401(k) and 403(b) Plans.
Section 604 of SECURE 2.0 created a new option for participants in 401(k) and 403(b) plans to elect to receive employer matching and nonelective contributions on a Roth basis. This is particularly attractive because beginning in 2024, 401(k) and other plan Roth accounts will no longer be subject to lifetime required minimum distribution (RMD) rules. This will create parity with the tax treatment under Roth IRAs, which have been excluded from the lifetime RMD requirements However, many vendors and plan sponsors were hesitant to implement this option, even though the SECURE 2.0 provision was effective on adoption in December of 2022, due to the lack of guidance. It was unclear, for example, whether partially vested participants could make elections and how to report the Roth employer contributions. As part of its year-end grab bag guidance in Notice 2024-02, the IRS recently answered many-but not all- of the open questions about this plan option in a welcome holiday present. Here is a summary of the rules:
How Do Participants Make Elections?
The rules are based on the current regulations on Roth deferral elections. The election must be made no later than the date the contribution is allocated to the participant’s account and must be irrevocable. In addition, participants must be given the effective opportunity to make or change Roth employer contribution elections at least once a year. Presumably, participants may make one election that applies to all contributions if employer contributions are made each payroll period.
Can Partially Vested Participants Make the Election?
Many 401(k) plans have graduated vesting schedules. Plan sponsors wondered whether they could permit elections of a portion of the employer contribution representing the participant’s vested percentage-for example, 40% of the contribution if the participant is 40% vested. The answer to that was a clear no. Participants must be 100% vested in order to make the Roth election. Limiting the Roth elections to fully vested employees will not be treated as a discriminatory benefit, right or feature.
Does the Plan Have to Permit Roth Deferrals or In-Plan Roth Conversions?
Since prior guidance on in-plan Roth conversions (see IRS Notices 2013-74 and 2010-84) required that in-plan Roth conversions could not be adopted unless a plan also permitted Roth contributions, plan sponsors wondered whether they needed to permit Roth deferrals and in-plan Roth conversions before they could add Roth employer contributions to their plans. The somewhat surprising answer here was no; a plan may permit only Roth employer contributions. Further, a plan that offers Roth employer contributions satisfies the requirement that plans must permit Roth contributions before they can permit in-plan Roth conversions. However, Notice 2024-02 cautions that the right to make designated Roth contributions is a benefit, right or feature subject to non-discrimination testing.
Are Roth Employer Contributions Included in Plan Compensations?
Roth employer contributions are not included in the safe harbor definitions of compensation in Reg. Sections 1.415(c )-2(d)(3) and (4). They are not wages.
How Are Roth Matching and Nonelective Contributions Reported?
Roth employer contributions are income in the year in which they are made regardless of when they would be treated as annual additions for purposes of Code Section 415 or the year in which they are deductible and are not subject to FICA, FUTA or income tax withholding. Roth employer contributions are reported to the IRS on Form 1099-R, the same form that is used for distributions.
When Are Plan Amendments Required?
As part of Notice 2024-02, which contains guidance on several other SECURE 2.0 provisions, the IRS extended the amendment deadline for recent statutory changes, including those enacted in SECURE 2.0, from the last day of the 2025 year to December 31, 2026, a welcome breather given the large number of changes enacted in SECURE 2.0. Collectively-bargained plans have until December 31, 2028 to adopt these amendments. This extension also applies to both required and discretionary amendments to pre-approved plans. However, plan sponsors implementing the Roth employer contribution option need to communicate the changes to participants on a timely basis and have recordkeeping in place to satisfy a e separate accounting requirement and track the holding period for favorable tax treatment of distributions. Fortunately, the timing of the new guidance allows any plan sponsors who did not wait for the guidance before implementing Roth employer contribution elections to correctly report the contributions.
The Bottom Line.
As a result of these new rules, allowing employees to elect to treat matching or nonelective contributions as Roth contributions has become more attractive, especially for plans that already permit Roth deferrals and in-plan Roth conversions. The elimination of lifetime RMD requirements means that participants will no longer have to roll their distributions into Roth IRAs to avoid the lifetime RMD rules, which has been a common practice. It would be reasonable to refer to prior IRS guidance on issues not covered in Notice 2024-02, such as whether these provisions are protected under Code Section 411(d). In-plan Roth rollovers, for example, are not protected under this provision.
However, most employers today do not have individually designed plans. Those that do not can offer Roth employer contributions only if their vendors offer and support this option. Given the many advantages of making Roth contributions, it is to be hoped that the new guidance will spur most vendors to make Roth employer contributions available to interested plan sponsors and participants sooner rather than later.