In 1997, the Internal Revenue Code was amended to permit individuals to make contributions to a new type of IRA called a “Roth IRA.”
Contributions to a Roth IRA are included in an individual’s income and, unlike distributions from a “traditional” IRA, distributions from a Roth IRA are not usually taxed. In 2005, an individual may contribute up to $4,000 ($4,500 if over age 50) to a Roth IRA.
Roth IRAs have become very popular because they allow individuals to save for their retirement without facing income taxes on their later withdrawals from their Roth IRAs.
Starting in 2006, the benefits of Roth IRAs will be expanded to 401(k) plans. This new feature is called a “Roth 401(k).”
What is a Roth 401(k)?
A Roth 401(k) is a part of a traditional 401(k) plan. It allows a participant to make after-tax Roth 401(k) contributions to a plan and usually allows distribution of the Roth 401(k) contributions (and earnings) without any further taxation.
Roth 401(k) contributions must comply with all of the requirements that apply to “traditional” 401(k) plan contributions and, for distributions to qualify as tax-free, must also comply with a series of special Roth 401(k) rules.
Benefits of a Roth 401(k)
There are several reasons to consider a Roth 401(k):
Roth IRA Contributions Are Not Available to Higher Paid Employees but Roth 401(k) Contributions Are
Individuals earning over $110,000 ($160,000, if married) are not eligible to make Roth IRA contributions. However, Roth 401(k)s are not subject to these income limits. A Roth 401(k) creates a new opportunity for highly compensated employees and officers to save for their retirement and receive 401(k) distributions on an “after-tax” basis.
Reduced Fees for Employees
Employees currently eligible to make Roth IRA contributions often have small account balances that lead to the imposition of annual account fees that eat away at their retirement savings. Roth 401(k) plans may help employees save more for their retirement without reduction for fees.
Higher Contribution Limits Than Roth IRAs
Many employees already contribute to Roth IRAs. However, the dollar limits that apply to Roth 401(k) contributions ($15,000 in 2006) are far greater than the basic Roth IRA contribution limit ($4,000 in 2006).
Long-Term Compounding for Younger Employees
Younger employees who will not need their retirement savings until a date far in the future will be able to pay taxes on their contributions today and have them grow on a tax-free basis until their retirement. As a result, earnings on their contributions will compound over a long period without being taxed in the future. Whether or not a participant will benefit from a Roth 401(k) will vary on a participant-by-participant basis.
Special Contribution Rules
There are a number of special rules governing contributions to a Roth 401(k) account:
Election of Roth 401(k) Contributions
The Roth 401(k) rules require that participants have the ability to elect between Roth and traditional contributions to their 401(k) plan. A participant must make an irrevocable election whether a contribution is a traditional, pre-tax contribution or a Roth 401(k) contribution before an amount is contributed to the 401(k) plan.
Separate Recordkeeping
Roth 401(k) contributions must be tracked separately from other contributions to a 401(k) plan.
Forfeitures
Forfeitures may not be allocated to Roth 401(k) accounts.
Allocation of Gains, Losses and Expenses
Gains, losses and plan expenses must be allocated between a participant’s Roth 401(k) and other 401(k) accounts on a reasonable basis.
Rollover Roth 401(k) Contributions
A Roth 401(k) plan may permit a participant to roll his or her Roth 401(k) accounts in other plans into a 401(k) plan permitting Roth 401(k) accounts. Separate recordkeeping will be required.
IRS Contribution Limits
Roth 401(k) contributions are subject to the maximum contribution limit that applies to traditional, pre-tax contributions. As a result, in 2006, the maximum combined amount of Roth and pre-tax contributions will be $15,000 ($20,000 for participants over age 50 if a plan permits catch-up contributions).
Nondiscrimination Testing
Roth 401(k) contributions are treated like traditional pre-tax contributions for purposes of applying the Internal Revenue Code nondiscrimination testing requirements. In addition, a Roth 401(k) feature must be made available to participants on a nondiscriminatory basis.
Matching Contributions
Employer matching contributions on Roth 401(k) contributions may not be made as Roth 401(k) contributions and must continue to be made on a pre-tax basis.
Special Distribution Rules
There are also a number of special rules governing distributions from a Roth 401(k) account:
Requirements for Tax-Free Distribution
Roth 401(k) contributions and earnings on these contributions are only tax free if they are distributed because of a participant’s reaching age 59½, a participant’s death or a participant becoming disabled.
In addition, Roth 401(k) contributions may not be distributed tax-free within five years of a participant’s first Roth 401(k) contribution to the plan or a predecessor Roth 401(k) plan.
Voluntary Rollover of Roth 401(k) Distributions
401(k) plans are already required to allow participants to roll their 401(k) plan distributions over to another 401(k) plan or an IRA. Roth 401(k) contributions will be subject to the same rules, except that rollover distributions of Roth 401(k) contributions must be made to another Roth 401(k) or a Roth IRA.
Mandatory Rollover of Involuntary 401(k) Distributions
Since March 28, 2005, plans that automatically cash out small participant account balances under $5,000 have been forced to automatically roll over a cashout valued between $1,000 and $5,000 to an IRA. These mandatory rollover rules also apply to cashed-out Roth 401(k) accounts valued between $1,000 and $5,000, except that these amounts will be automatically rolled into a Roth IRA.
Required Minimum Distributions
Unlike Roth IRAs, where distributions do not have to begin during the Roth IRA owner’s lifetime, Roth 401(k) accounts must be distributed according to the same minimum required distribution rules applicable to traditional 401(k) contributions.
Unresolved Issues
Although many of the basic rules governing Roth 401(k)s are clearly addressed by the Internal Revenue Code and existing IRS guidance, a number of additional open issues are expected to be addressed by the IRS in coming months. These issues include the following:
Rollover Contributions From Roth IRAs
Many employers allow employees to roll their regular IRAs into their 401(k) plan. It is unclear whether a Roth IRA may be rolled into a Roth 401(k) plan.
Loan Defaults
Many 401(k) plans permit participants to request and receive loans from their 401(k) plan accounts. If a participant defaults on his or her loan, he or she is generally subject to income tax on the amount defaulted.
It is not clear whether a defaulted loan that was taken (either in whole or in part) from Roth 401(k) contributions will be taxed as a distribution or whether a defaulted loan may qualify for the tax-free treatment given to most Roth 401(k) distributions.
Sunset Provision
Aside from issues to be addressed by upcoming IRS guidance, there is a potential longer-term issue for Roth 401(k)s—the statutory “sunset” of these plan provisions after 2010. Roth 401(k)s were added to the Internal Revenue Code in 2001 with a January 1, 2006, effective date. However, they are due to automatically “sunset” after 2010.
If Congress does not extend or eliminate this sunset, the IRS will need to issue additional guidance and Roth 401(k) plans will likely need to be amended again to discontinue future Roth 401(k) contributions.
Impact on Plan Sponsors
Plan sponsors that elect to implement Roth 401(k) contributions will face a number of additional requirements and communications issues:
Reporting and Withholding of Contributions
An employer must report Roth 401(k) contributions on a participant’s W-2. Also, because Roth 401(k) contributions are taxed, withholding taxes attributable to Roth 401(k) contributions must be withheld from a participant’s income.
Communication with Participants
Many employees will be familiar with the concept of after-tax contributions from their experience with Roth IRAs. However, for many other employees, Roth 401(k) contributions will be a new concept that will need to be explained to employees. Clear participant communications will be essential to avoid confusion among this group of employees.
Plan sponsors will want to tread carefully to limit the risk that participants will later assert that they were improperly directed to Roth 401(k) contributions over traditional, pre-tax contributions (or vice versa).
Plan Amendments
Employers must amend their plan documents and update their summary plan descriptions to reflect the Roth 401(k) rules if they are going to make Roth 401(k) contributions available to their employees.
Conclusion
Roth 401(k)s are an exciting new feature that may benefit many employees. Although Roth 401(k)s are not permitted prior to January 1, 2006, there are a number of design and logistical decisions that will need to be considered before Roth 401(k) contributions are put into place.
An employer considering Roth 401(k) contributions should consult with its advisors and service providers to discuss what changes would need to be made to its plan document, summary plan description, other plan materials, service agreements, payroll systems and recordkeeping systems to implement the Roth 401(k) rules.
This newsletter is intended to provide general information on matters of interest in the area of qualified retirement plans and is distributed with the understanding that the publisher and distributor are not rendering legal, tax or other professional advice. Readers should not act or rely on any information in this newsletter without first seeking the advice of an independent tax advisor such as an attorney or CPA.
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Spring will arrive soon, promising new growth and a fresh beginning. It could also be the perfect time to do some spring cleaning for your plan. Let’s look at some areas that you might consider reviewing to ensure your retirement plan is operating efficiently.
Document your processes and procedures to make certain that plan tasks can be handled in case of any absences during an enrollment or pay period. Having a backup in place can prevent errors and delays that could lead to penalties.
Make sure to have a process in place to notify all new enrollments of their eligibility, regardless of whether the plan has automatic enrollment. Depending on the timing for plan entry, including the plan enrollment paperwork with the new hire paperwork could make entry easier for you. Please reach out with any questions regarding when an employee enters the plan.
Deposits of employee deferrals and loan repayments must be submitted to the plan as soon as possible to avoid penalties and corrections. For plans with less than 100 participants, a safe harbor rule allows deposits to be made within seven business days. For larger plans, the expectation is that the money will be deposited more quickly. Depositing these funds on the pay date will avoid the possibility of being late.
Monitoring deferral contribution limits during the calendar year will avoid refunds after year end. Make sure that your payroll is set up to stop deferrals once the limit is reached, including any catch-up contributions for those who have reached age 50.
To keep the plan in compliance, employer contributions must be deposited timely. Due dates are impacted by the type of contributions, required status and tax deductibility. If you have questions on when to deposit your employer contribution or even whether to make an employer contribution, please contact us.
Most plans must be covered by a fidelity bond. The minimum coverage is 10% of plan assets (rounded up to the next $1,000) and the maximum coverage is $500,000. Additional requirements apply to plans with employer securities or non-publicly traded assets. If your fidelity bond is insufficient, now is the time to raise the coverage. Inflation clauses that increase the bond amount as the plan assets increase can ensure that your bond coverage is always adequate. Contact us or your insurance provider if you don’t have a fidelity bond.
Another area to review is communication with participants. Helping your employees understand and trust the plan can increase their contributions. Be sure that your procedures include distributing any plan-related communications—including required participant notices.
Distributions also involve communication, including some of the aforementioned notices. Discussing distribution options with terminated participants, possibly as part of an exit interview, can help to reduce risk of lost participants. We’ll provide instruction on distributions for force-out distributions for small balances, testing corrections and required minimum distributions.
Your plan document is the legal source on how the plan should be administered; operating within its parameters is critical. It’s always worth taking time to review the plan document to ensure that you fully understand and are following its provisions. We’ll cover more details about the plan document later in this newsletter. We’re here to support you in keeping your plan in compliance. Please feel free to reach out with any questions.
Addressing the Challenge of Uncashed Distribution Checks
Uncashed distribution checks present a persistent and often overlooked challenge for retirement plan sponsors. Despite the best efforts of plan administrators, some participants fail to cash their distribution checks, leading to administrative burdens, fiduciary concerns and potential compliance issues. A recent publication by Retirement Management Services (RMS) sheds light on this issue and offers practical guidance for employers seeking to manage and mitigate the risks associated with uncashed checks.
Uncashed checks can arise for various reasons. Participants may have moved without updating their contact information, may not recognize the check as legitimate or may simply forget to deposit it. Regardless of the cause, the responsibility for addressing these uncashed funds ultimately falls on the plan sponsor. This creates a fiduciary obligation to act in the best interest of the participant while ensuring compliance with IRS and Department of Labor (DOL) regulations.
Sponsors are encouraged to maintain up-to-date contact information for all plan participants and to follow up promptly when checks remain uncashed. This may involve sending reminder letters, making phone calls or using certified mail to confirm receipt. In some cases, plan sponsors may also consider using electronic payment methods to reduce the likelihood of checks going uncashed in the first place.
The IRS and DOL have issued guidance on how to handle these situations, including the use of forfeiture accounts and escheatment to state unclaimed property programs. However, these options come with their own set of rules and potential pitfalls. For example, using a forfeiture account may require the plan document to explicitly allow for such treatment. Escheatment laws, which allow the government to assume control of unclaimed property, vary by state. As such, plan sponsors must carefully evaluate their options and consult with legal or compliance experts as needed.
Another important consideration is the documentation of all the efforts made to contact participants and resolve uncashed checks. Maintaining a clear audit trail can help demonstrate fiduciary prudence and protect the plan sponsor in the event of an audit or legal challenge. It is extremely important to have a written policy in place that outlines the steps to be taken when a check remains uncashed beyond a certain period.
By taking a proactive, well-documented and compliant approach, employers can fulfill their fiduciary duties, reduce administrative burdens and ensure that participants receive the benefits they are entitled to.
Source: Retirement Management Services – “Uncashed Distribution Checks” https://www.consultrms.com/Resources/59/Plan-Sponsor-Tips-and-Help/212/Uncashed-Distribution-Checks
Divorce and the Retirement Plan
When a participant in a qualified retirement plan undergoes a divorce, the participant’s account balance may be an asset that is split with the former spouse. As the plan exists for the exclusive benefit of its participants, a court order is required to transfer the participant’s benefits to the ex-spouse. Once approved by the plan administrator, this court order is called a Qualified Domestic Relations Order (QDRO).
The QDRO is a judgment, decree or order that must be issued by a state authority (usually a court). It can be part of the divorce settlement or it may be a separate document. Because of the serious nature of separating the participant’s account balance, the QDRO is more than just an agreement made by both parties — it must also be signed by a judge.
A QDRO will describe how to divide the participant’s account balance between the participant and the ex-spouse, referred to as the alternate payee. In some cases, a set dollar amount will be allocated; in others, a percentage of the account may be designated. In the latter case, the amount assigned to the alternate payee represents the given percentage of the participant’s total vested account balance as of a specified valuation date. This percentage will apply to all sources — such as deferrals, matching or profit sharing — unless specified by the QDRO. Any interest and investment gains/losses that accrue between this valuation date and the date the funds are separated into an account for the alternate payee are often factored into this final calculation. If the participant has outstanding loans, the QDRO will usually indicate how the loans are handled.
Contributions such as deferrals and employer matching made after the valuation date are credited to the participant’s account. Earnings and losses are applied to the account balances. Once the division is complete, the alternate payee’s portion (either dollars or shares) is transferred to an account in the alternate payee’s name.
If the plan allows, the alternate payee may be paid out in a cash or rollover distribution. Not all plan documents allow the alternate payee to receive a distribution before reaching normal retirement age, so it’s important to follow the terms of the plan. In addition, the QDRO cannot violate the provisions of the plan document by requiring a plan to provide an alternate payee or participant with any type or form of benefit not otherwise provided under the plan.
Although the most common situation for a QDRO is a divorce, it can be issued in other situations, such as to a dependent in the case of child support. If the alternate payee is a minor child or legally incompetent, the order can also require payment to the individual with legal responsibility for the alternate payee. If a participant or their attorney provides you with a copy of a divorce decree that references the plan or a QDRO, please contact us immediately, and we will work with you to ensure it meets the requirements of the plan.
Important note for defined benefit plans: For 2025 plan years, PBGC premiums are due one month earlier than usual, specifically on the 15th day of the ninth month after the beginning of the plan year. For calendar year plans, this means the premium is due on September 15, 2025, instead of the usual October 15. This accelerated deadline is due to a provision in the Bipartisan Budget Act of 2015.
Upcoming Compliance Deadlines for Calendar-Year Plans
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