Question: Can a participant in a 401(k) plan make contributions on an after-tax basis?
Answer: Beginning January 1, 2006, it is permissible to make after-tax contributions to a 401(k) plan. However, this feature in a 401(k) plan, also known as a “Roth 401(k),” is not required; therefore, whether an individual is permitted to make an after-tax contribution depends on whether the employer made an adopting amendment.
Prior to January 1, 2006, an individual could make only pre-tax contributions to a traditional 401(k) plan (which are later taxed upon distribution). Roth 401(k)s are a dramatic departure from the traditional 401(k) because, if adopted by the employer, it gives participants the choice of contributing pre-tax or after-tax dollars. Any amount designated as a Roth contribution will be includible as taxable income to the employee at the time of contribution (i.e., therefore, no taxation at the time of distribution). As to the nuts and bolts of the Roth 401(k), it is designed to be a separate account within a 401(k) plan and work in the following manner:
· all participants in the 401(k) plan are eligible to contribute to the Roth 401(k) without regard to the participant’s gross income (in contrast, individuals surpassing a certain gross income threshold are not eligible to contribute towards a Roth IRA);
· contributions are made to the Roth 401(k) account on an after-tax basis (similar to Roth IRAs) and must be fully vested;
· distributions are tax-free only if the distribution is due to: (i) the participant’s death, disability or attaining age 59 ½ or older, AND (ii) it occurs at least five years after the date the participant made his or her first Roth 401(k) contribution;
But with the new plan design comes an increased administrative burden to those employers adopting Roth 401(k) accounts. First, the 401(k) plan must be amended to permit Roth 401(k) accounts. Once adopted, the employer must satisfy withholding obligations for any contributions made to a Roth 401(k) account (this could be a significant cost detriment to large employers). Third, the employer must separately account for contributions made on a pre-tax and after-tax basis. Lastly, the employer must ensure the participant takes required minimum distributions upon his or her attaining age 70 ½ (though this legal requirement is awkward since the Roth 401(k) account can be rolled over to a Roth IRA which is not subject to minimum distribution rules).
Anthony J. Eppert is a benefits and compensation attorney in Luce Forward, Hamilton & Scripps LLP’s San Diego office. He can be reached at (619) 699-2506 or aeppert[at]luce.com. Founded in 1873, Luce Forward is a full service law firm serving all of California with offices in San Diego, Carmel Valley/Del Mar, Los Angeles, and San Francisco.