Designated Roth Accounts
The tax code allows several kinds of retirement plans that reduce taxes either now or in the future. The 1st types of retirement plans, such as the traditional IRA, saves taxes when contributions to the retirement accounts are made, thus, motivating people to save for their future. Not only are the contributions tax-deductible, but the money can grow tax-free. However, these accounts are tax-deferred accounts, since the government assesses taxes on both contributions and earnings when the money is withdrawn. Later, the government allowed a new type of account, called a Roth IRA, that required contributions with after-tax dollars, but distributions of both contributions and earnings are tax-free. For many people, especially lower income people who did not benefit significantly from the tax savings of traditional, pretax retirement accounts, especially since the pretax contributions do not save on employment taxes, which is usually a greater burden on lower income people, the Roth IRA was a much better deal. Because of the popularity of the Roth IRA, the government changed some of the traditional types of retirement plans — notably the 401(k), the 403(b), and the 457(b) government retirement plans, including the Solo 401(k) plan for the self-employed with no employees — so that the taxpayers could designate some or all their contributions to a separate designated account within their retirement plan, called appropriately enough, a designated Roth account. Like contributions to a Roth IRA, contributions to a designated Roth account are made with after-tax dollars, but qualified distributions from designated Roth accounts, consisting of both contributions and earnings, are tax-free. However, only employees can contribute to their designated Roth account — employer contributions are permitted only for the tax-deferred accounts. Note that simplified employee pension plans (SEP), also known as a SEP-IRA, and SIMPLE IRAs do not have designated Roth accounts: all contributions to these plans are pretax.
Although the tax code allows designated Roth accounts, the retirement plan must also allow it. A designated Roth account is set up for each plan participant who requests it and the account is kept separate from the pretax retirement account, facilitating accurate accounting.
Secure Act 2.0
The Secure Act 2.0, passed at the end of 2022, makes it easier for employers to help workers open emergency savings accounts, assist employees who are repaying student loan debt and allow part-time workers access to retirement plans in 2 years instead of 3. There are also new benefits to both Roth IRAs and Roth 401(k)s, including moving leftover money from a 529 college savings account to a Roth I.R.A. Certain rules must be followed to avoid taxes and penalties, and there are some income restrictions. However, some provisions start in different tax years.
Secure Act 2.0 Changes for Employees with 401(k) Plans:
- Increases the required minimum distribution (RMD) age from 72:
- to 73 in 2023
- to 75 in 2033
- The penalty for not taking an RMD on time has been reduced from 50% of the amount that should have been withdrawn to 25%, and to 10% for IRAs if corrected.
- Employers could allow their employees to make 1 withdrawal, up to $1000 annually from their 401(k) or IRA, for certain emergency expenses without owing the 10% additional penalty for nonqualified distributions.
- An emergency is defined as an unforeseeable or immediate financial need related to the employee or his family.
- Employees can choose to repay the amount within 3 years, but if they choose not to, then they cannot make another emergency withdrawal for 3 years.
- Starting in 2025, the catch-up contribution limits for taxpayers aged 60 to 63 increases from $7500 per year to at least $11,250.
- The new rule says that the limits would increase to the greater of $10,000 or 50% more than the regular catch-up amount that year.
- But since the catch-up amount already = $7500,
- 50% more = $7500 + $3750 = $11,250
- Taxpayers earning more than $145,000 must put the catch-up money in a Roth 401(k).
- Starting in 2025, this wages threshold will be adjusted annually for inflation, rounded down to the lowest multiple of $5,000.
- So high income taxpayers will have to pay taxes on their catch-up contribution.
- Lower-income taxpayers may choose a pre-tax or after-tax contribution.
- The new rule says that the limits would increase to the greater of $10,000 or 50% more than the regular catch-up amount that year.
- Starting in 2024:
- Allow employees to make qualified student debt payments eligible for employer matches to a retirement account.
- Allows a one-time penalty-free withdrawal from a 401(k) or an IRA for an emergency, defined as an unforeseeable or immediate financial need related to the employee or his family.
- eliminates required minimum distributions from 401(k) Roth accounts.
- So, Roth accounts will be treated the same as Roth IRAs in regard to RMD’s.
Secure Act 2.0 Changes for Employers with 401(k) Plans:
- Employers must allow longer-term part-time employees to participate, including those with 1 year of service of at least 1,000 hours, or 2 consecutive years with 500 hours of service each year.
- Employers will be permitted to automatically enroll workers into emergency savings accounts, linked to employees’ retirement accounts.
- Contributions can be up to 3% of their salary, up to a maximum of $2500.
- These emergency savings accounts are like Roth accounts; contributions are taxed but withdrawals are tax-free.
- New employer plans created after 2024:
- Requires employers to automatically enroll workers into 401(k) and 403(b) plans once they become eligible while also allowing them to opt out if they so choose.
- The initial contribution rate must be at least 3% but not more than 10%.
- Contributions must increase 1% each year until reaching at least 10%, but not more than 15%.
- Plans created before 2025 do not have to follow these new rules.
- small businesses with no more than 10 workers
- new businesses operating for less than 3 years
- church and government plans.
Setting Every Community Up for Retirement Enhancement (SECURE) Act of 2019 (SECURE Act)
Setting Every Community Up for Retirement Enhancement (SECURE) Act of 2019 (SECURE Act) has changed the law regarding qualified tax-deferred retirement accounts:
- beneficiaries of tax-deferred retirement plans must receive the full distribution within 10 years after the death of the employee or account holder;
- the age for starting required minimum distributions has been increased from 70½ to 72;
- distributions from retirement plans can be penalty-free if used to pay for expenses of a birth or an adoption;
- pension and benefit plan administrators must disclose the plan's lifetime income stream to the beneficiaries;
- part-time employees may participate in 401(k) plans if they worked at least 500 hours annually for a minimum of 3 consecutive years and are at least 21 years of age at the end of the 3-year period that must start after 2020.
The plan participant can decide what proportion of her contribution will go to the pretax retirement account or to the designated Roth account. However, the overall dollar limit that applies to these accounts applies to the total contribution to both pretax and designated Roth accounts. So, for instance, the contribution dollar limit for 2020 is $19,500, and for plan participants who are at least 50 by year-end can make a catch-up contribution of an additional $6500, for a total of $26,000. So if a 50-year-old plan participant chooses to save $11,000 in the pretax account, then any contribution to the designated Roth account in the same tax year is limited to $15,000. Once the contribution is made to a designated Roth account, the participant cannot recharacterize the contribution as a pretax contribution. However, distributions from pretax accounts can be rolled over into the designated Roth account, but the participant must pay taxes on the rollover amount for that year.
If the retirement plan provides, the employer can match contributions to a designated Roth account, but the matching contributions are paid into the pretax account rather than the designated Roth account.
Rollovers to or from designated Roth accounts are restricted. A Roth IRA can only be rolled over into another Roth IRA: it cannot be rolled over into a designated Roth account. A designated Roth account can be rolled over into another designated Roth account, but to be excludable from income, the rollover must be direct, from trustee to trustee. Moreover, unlike a Roth IRA, which can accept rollovers from virtually any type of retirement account, rollovers to designated Roth accounts cannot be recharacterized, so pretax accounts cannot be rolled over to designated Roth accounts. Hence, the only permitted rollovers to a designated Roth account must come either from other designated Roth accounts or from a Roth IRA.
Although the 5-year holding period rule applies to each designated Roth account separately, the age of the rolled over account will be determined by the age of the oldest account. So if a designated Roth account that has been held for 5 years is rolled over to another account that was just opened, then the 5-year holding period will be satisfied for the new account.
However, the holding period does not transfer to a Roth IRA. Instead, the holding period for the Roth IRA, including rollover amounts from designated Roth accounts, is determined by the tax year for which a Roth IRA was 1st opened. Since contributions to a Roth IRA can be made up to the tax filing deadline, the 5-year period begins on January 1 for the tax year for which contributions were made. Therefore, if you held a Roth IRA for at least 5 years, then the 5-year holding period is satisfied, so any rollovers from a designated Roth account into any Roth IRA will be immediately available without withdrawn earnings being subject to taxes. Note that, unlike designated Roth accounts, the holding period for all Roth IRAs is determined by the date in which the 1st Roth IRA was opened, so if any Roth IRA was held for at least 5 years, than any rollovers from a designated Roth account into any Roth IRA held by the same taxpayer will satisfy the 5 year holding requirement. Like the designated Roth account, the principal of the Roth IRA can always be withdrawn without taxes or penalties, even if the taxpayer is younger than 59½, but an unqualified withdrawal of earnings will incur a 10% penalty on the earnings. Unlike designated Roth accounts, any withdrawals from a Roth IRA are considered 1st from principal, or basis, then from earnings. So a taxpayer can withdraw all contributions to a Roth IRA at any time without penalty.
Pretax contributions from 401(k), 403(b), and 457(b) retirement plans can also be rolled over into a designated Roth account. However, taxes must be paid on the rolled over amounts. Amounts held in a traditional IRA, SEP-IRA, or a SIMPLE IRA cannot be directly rolled over into a designated Roth account, but they can be rolled over into 401(k) type plans as a pretax rollover, then rolled over into the designated Roth account. Moreover, a SIMPLE IRA cannot be rolled over into any other type of retirement plan, except another SIMPLE IRA, until the SIMPLE IRA has been opened for at least 2 years.
If a retirement plan allows in-plan Roth rollovers, participants can rollover amounts held in pretax accounts to a designated Roth account within the same plan, including the portion contributed by the employer. Legally, any retirement plan that allows designated Roth accounts can also offer in-plan Roth rollovers. The rollover can be a direct rollover, in which the funds are transferred directly from trustee to trustee or from the pretax account to the designated Roth account administered by the same trustee, or the participant can rollover the amount received in a distribution to a designated Roth account within the same plan within 60 days of receiving the distribution. The employer is legally obligated, however, to withhold 20% of a distribution paid directly to the recipient for potential taxes; direct rollovers are not subject to tax withholding. Beneficiaries and alternate payees may also make in-plan Roth rollovers, but only if the transferor is eligible for the distribution from the source account.
Distributions from designated Roth accounts follow the same rules as distributions from pretax accounts. Unlike Roth IRAs, where withdrawals can be made at any time, withdrawals from designated Roth accounts, like other qualified retirement plans, are allowed only when the retirement plan allows it. The tax treatment of the distribution depends on whether it is qualified or nonqualified.
Qualified distributions from a designated Roth account are tax-free. A qualified distribution is made to a participant who is at least 59½ and at least 5 years have passed since the beginning of the 1st tax year for which contributions to the account were made, or who has become disabled or died. Unlike Roth IRAs, the 5-year holding period required for designated Roth accounts applies to each account. If a designated Roth account is rolled over into another designated Roth account, then the 5-year holding requirement begins with the oldest account. So if a designated Roth account that has been held for 5 years is rolled over to another account that was just opened, then the 5-year holding period will be satisfied for the new account. Funds in a designated Roth account can also be rolled over into a Roth IRA where the 5-year rule for Roth IRAs applies.
If the distribution is not qualified, then the part of the nonqualified distribution attributed to earnings is taxable; the part attributable to contributions is tax-free, since the contributions were made with after-tax dollars. This treatment differs from Roth IRAs, where nonqualified distributions are considered from contributions 1st, then from earnings, but any distributions from designated Roth accounts are prorated between nontaxable contributions and taxable earnings. To calculate the taxable portion of a distribution attributable to earnings, use the following procedure:
|Taxable Portion of Nonqualified Distribution||=||Distribution||×||Total Earnings |
Total Account Balance
So if a designated Roth account has a total balance of $5000, of which $1000 is earnings, then a nonqualified distribution of $2000 will have a taxable portion equal to $2000 × 1/5 = $400.
If the retirement plan allows hardship distributions, then a participant can elect to take a distribution because of a financial hardship, but, unless the distribution is also qualified, the earnings portion of the distribution will be includible in the participant's gross income. However, the tax can be avoided, if the distribution is rolled over into a Roth account within 60 days. A rollover to another designated Roth account in another retirement plan can be made, but the transfer must be a direct rollover.
Some retirement plans will also allow loans, where up to 50% of the value of the retirement account, including pretax and after-tax contributions and earnings can be used as collateral for a loan, up to a maximum loan of $50,000.
Unlike a Roth IRA, but like a traditional IRA, the taxpayer must receive required minimum distributions by April 1 of the year after the year in which the taxpayer reaches 72, unless the taxpayer is still working for the employer and is not a 5% owner of the employer that sponsors the plan.