Thinking of Adding a Designated Roth Option to Your Plan? Consider This

Barbara Webb, TGPC

The Economic Growth and Tax Relief Reconciliation Act of 2001 created a new type of elective deferral, under certain employer plans, called a designated Roth contribution. These Roth elective deferrals do not reduce the employee’s taxable wages for the year and are thus made to the employer’s plan as “post-tax” contributions, but “qualified” distribution of designated Roth elective deferrals — plus the associated earnings — could be tax-free if certain conditions are met.

Theoretically, designated Roth contributions are an alternative to Roth IRA contributions for participants whose income exceeds the threshold limits, because no phase-out range applies. Another draw is that the contribution potential is higher than with Roth IRAs since the larger dollar limitation for regular deferrals also applies to Roth deferrals. Factor in employer matching contributions, if offered, although they must be made to a different account within the plan and not directly to the designated Roth account.

To offer this program is not without strings, however. Here is a list of elements to consider before implementing a designated Roth option under an employer plan:

The combination of pre-tax and post-tax deferrals cannot exceed annual limits. Participants must be given the choice of contributing to the pre-tax or designated Roth account, but the total deferral limit for the year must be observed.

Separate accounting records are required. All contributions to the designated Roth account, as well as all attributable gains and losses, must be separately record-kept.

Participants may not subsequently “recharacterize” Roth contributions. Once a participant chooses to allocate their deferral to the designated Roth account, there is no possibility to later re-allocate the contribution to the pre-tax side. (The Roth option can later be rolled into a Roth IRA, when eligible.)

Required Minimum Distributions (RMDs) must be taken from the designated Roth account (later of attainment of age 70½ or the year of severance from employment). Unlike Roth IRAs, these withdrawals apply if the employee is an owner (not seen in the 403(b) or 457(b) market segment) or has severed employment. Participant can, however, roll the account into a Roth IRA (when eligible for a distribution) and avoid RMDs altogether.

Rollover opportunities are limited. Eligible rollover distributions from a Designated Roth account may only be rolled over to another Designated Roth account or to a Roth IRA.

To incorporate a Roth contribution program into an employer plan, the plan must be amended. Designated Roth features must be written into the plan and all contribution, distribution, investment and rollover provisions must adhere to the plan’s terms.

Notification requirements should also be considered. Participants need to be notified that this option is available and plans subject to ERISA must update their summary plan description or provide a summaries of material modifications. Applicable sections of certain administrative forms will change as well, such as the salary deferral agreement, distribution forms and the Special Tax Notice (402(f)) to name a few. And the payroll department of the employer will need to understand how the Roth deferral is handled differently from the pre-tax deferral.

Finally, here are two notes worth mentioning regarding Roth deferrals:

• These are, as mentioned earlier, “post–tax” contributions. Be careful if you refer to them as “after-tax contributions.” Remember after-tax contributions are already permitted under some plans and are not the same as a Roth contribution.

• Although the expression “Roth 403(b)” is commonly used throughout the industry, there is no such thing as a “Roth 403(b)” or a “Roth 401(k)”! In order for an employer to add the Roth feature, they must already have in place the option of a pre-tax deferral. It is a requirement that the Roth be elected by the participant “in lieu of” or in addition to the pre-tax deferral. Referring to the plan as a “Roth 403(b)” is merely referencing one type of contribution source not a plan type.

Barbara Webb, TGPC, is Director of Technical Services for PenServ Plan Services, Inc.

Opinions expressed are those of the author and do not necessarily reflect the views of NTSA, or its members.