Be(A)ware of Roth IRA and Roth Employer Plan Differences
By Mike Rahn, CISP
Today, individuals tend to take for granted their ability to make Roth IRA contributions and designated Roth contributions. Roth IRAs have been with us since 1998, created by the Taxpayer Relief Act of 1997 (TRA-97). The option to make designated Roth contributions in 401(k), 403(b), and governmental 457(b) plans was created by the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), becoming effective for 2006 and later tax years. Not all eligible employers offered it immediately, but the Roth deferral option is now prevalent in most such employer plans.
Although Roth IRAs and designated Roth accounts have a few similarities, such as the name “Roth” and the objective of generating tax-free earnings, there are also some significant differences between the two accounts.
Does income potentially restrict a taxpayer’s ability to make Roth contributions?
Taxpayers whose modified adjusted gross income exceeds certain threshold amounts and phase-out ranges cannot make Roth IRA contributions. On the other hand, designated Roth contributions in 401(k), 403(b), or governmental 457(b) plans are not restricted by one’s income, no matter how great.
What events lead to tax-free earnings in a Roth savings arrangement?
Roth IRA earnings become tax free after the IRA owner meets a five-year clock, which begins on January 1 of the year for which the IRA owner makes his first Roth IRA contribution, and one of the following events occurs: attainment of age 59½, death, disability, or a first-time home purchase. Designated Roth account assets in employer plans have similar timing and event requirements, except for one—a first-time home purchase does not yield tax-free earnings.
Are all Roth distributions treated the same?
When conditions necessary for tax-free earnings are met in either a Roth IRA or a designated Roth account, all distributions from either account type are tax-free. These distributions are known as “qualified” distributions. But when a “nonqualified” distribution is taken—meaning, the earnings are not yet tax-free—the tax implications are very different. Roth IRAs are subject to certain ordering rules: all contributions are distributed first, followed by any conversion and employer plan rollover assets. Once those assets have been withdrawn, the earnings will be distributed. (See Qualified vs. Nonqualified Roth IRA Distributions, for more information on the Roth IRA ordering rules.) Nonqualified designated Roth account distributions are taxed based on a pro rata share of nontaxable contributions and taxable earnings. In both cases, any taxable earnings that are distributed may be subject to the 10 percent early distribution penalty tax.
What are the portability options for Roth assets?
Individuals may only roll over or transfer Roth IRA assets to other Roth IRAs. Designated Roth account assets may be rolled over to Roth IRAs, or to other employer plans that have a Roth deferral feature.
Can taxpayers change their mind—Roth vs pretax—after making a contribution?
Taxpayers can change Roth IRA contributions to Traditional IRA contributions by “recharacterizing” the contributions. Taxpayers generally have until October 15 of the year following the year for which the contribution was made to complete a recharacterization. The reverse—Traditional IRA-to-Roth IRA recharacterizations—are also available. But designated Roth contributions cannot later be changed to pretax contributions, and vice versa.
Are Roth assets subject to required minimum distribution (RMD) rules?
Since their inception Roth IRAs have been exempt from the RMD rules that apply to Traditional, SEP, and SIMPLE IRAs. Designated Roth account assets, however, are subject to the RMD rules. But if such amounts are rolled over to a Roth IRA, they have the RMD exemption that applies to Roth IRAs. (SECURE 2.0 has made designated Roth assets in employer plans exempt from RMDs, but this does not take effect until 2024. Designated Roth account contributions will remain subject to nondiscrimination requirements, such as ADP testing, if they apply.)
Can employer contributions to retirement plans be Roth in nature?
Before SECURE 2.0 was enacted, all employer contributions, such as matching, profit sharing, or other required or optional employer contributions were pretax in nature. This will change going forward, and employer matching or nonelective contributions will be able to be treated as Roth assets. Although SECURE 2.0 has made this option immediately available, the absence of IRS guidance on administrative procedures currently makes it difficult—if not impossible—to implement.
Can taxpayers make Roth contributions to other employer plans, like SEP and SIMPLE IRA plans?
SECURE 2.0 has expanded the Roth contribution option to SEP and SIMPLE IRA plans. This includes both employee salary deferrals and employer contributions. Although this is technically an option for the 2023 tax year, the lack of IRS guidance on administrative and reporting procedures remains an obstacle to implementation.
Is there a way to make existing non-Roth IRA and employer plan assets Roth in nature? Taxpayers can convert Traditional, SEP, and SIMPLE IRA assets to a Roth IRA, the immediate effect of which requires taxpayers to include the pretax IRA amounts in their ordinary income. Converted amounts are not subject to the 10 percent early distribution penalty tax. Non-Roth amounts in employer plans can similarly be made Roth in nature—plan permitting—by an in-plan Roth rollover, with essentially the same result as a Roth IRA conversion. These transactions cannot be reversed, so tax consequences should be considered carefully first.
