Employee 401(k) Plans: Tax Considerations for Employer Roth Contributions
As businesses seek to enhance retirement benefits for their employees, Roth employer contributions have emerged as a popular option. The SECURE 2.0 Act of 2022 introduced provisions that allow employers to offer both matching and discretionary contributions on a Roth basis. While this can provide long-term tax advantages for employees, it also introduces new tax and compliance concerns that employers must consider.
Tax Treatment of Employer Contributions
Traditionally, an employer’s contributions to a 401(k) plan are made on a pre-tax basis—that is, the employer’s contributions are not reported as taxable income for the employee. The contributions grow on a tax-deferred basis and are not taxed until the employee eventually withdraws them.
Employer Roth contributions offer a new alternative. Under SECURE 2.0, Roth treatment is now allowed for both matching contributions and nonelective contributions, including those made on a discretionary basis, such as annual profit-sharing contributions. If all requirements are met and the employee opts in, employers may choose to offer matching or discretionary contributions that are taxed upfront but grow tax-free, similar to an employee’s Roth contributions.
In other words, employees must pay income tax on the employer’s contributions in the year they are made. The contributions grow tax-free, and both the contributions and the account’s earnings and appreciation can be withdrawn tax-free in retirement, provided the employee has reached age 59½ and held the Roth account for at least five years. Contributions can be withdrawn tax-free before retirement, but a withdrawal of earnings would be subject to both income tax and an early withdrawal penalty.
Note that employers are not required to offer Roth contributions—or any employer-funded contributions at all. Furthermore, if they choose to offer Roth contributions, they are not required to offer them exclusively. If the plan is properly amended and designed, employers can allow each eligible employee to elect how his or her employer contribution is made. Employees may still choose how they make their own 401(k) plan contributions—on either a pre-tax or Roth basis—regardless of how they elect to receive any employer contribution.
Compliance Considerations and Other Concerns
Businesses that choose to offer Roth contributions must navigate several compliance requirements:
- Amend Plan Documents and Procedures. The first and most fundamental step is to amend the retirement plan documents to explicitly allow employer Roth contributions. Plan administrators should work closely with legal and tax advisors to ensure proper documentation, as well as proper procedures for managing both the traditional and Roth components of employees’ accounts.
- Coordinate Payroll Compliance. Second, companies must ensure that Roth contributions are properly reported as taxable income by providing each employee with a Form 1099-R. Employers will need to coordinate this reporting with the plan administrator.
- Establish Employee Elections. Because employer Roth contributions are not the default option, employees must affirmatively elect to receive them. If the plan’s rules and procedures permit it, employees may be allowed to change their election every year, but their election is locked in for the year once it is made. Employers need to establish clear communication and election procedures to handle this.
- Confirm Vesting and Eligibility. Under the SECURE 2.0 rules, an employer can deposit contributions on a Roth basis only if the employee is already 100% vested in those contributions. If a plan has a vesting schedule (such as 20% vested per year over 5 years), only those employees who have reached 100% vesting are eligible for Roth contributions. This rule prevents employees from being taxed on money they might not get to keep if they leave the company before they are fully vested.
Planning and Implementation
Before choosing to offer Roth employer contributions, employers should consider the potential for unintended impacts. If the pros, such as the ability to better attract and retain valued employees, outweigh the cons, the employer should then carefully plan how to implement this feature. Key factors to consider include:
- Administrative Costs. In addition to requiring amendments to plan documentation, adding the option of Roth employer contributions could further complicate the ongoing maintenance of retirement accounts. Plan administrators are likely to adjust their fees to reflect the additional tracking, testing, and reporting requirements. Another factor to consider is that beginning Jan 1, 2026, employee catch-up contributions (for employees over age 50) made by employees with prior year wages exceeding $145,000 (or the indexed amount) must be treated as Roth contributions. As a result, employers will need to amend their plans and account for Roth contributions within their plans or cease to offer the option of catch-up contributions..
- Reporting: Employees need to receive a Form 1099-R reporting the Roth contribution in the year it is funded, even if the contribution relates to the employer’s prior tax year. This requires further coordination between the payroll system and the 401(k) plan administrator.
- Employee Education. Employees need to understand both the immediate and long-term tax impacts of an employer Roth contribution. To facilitate this, employers can offer financial wellness programs or partner with professional financial advisors to help employees make informed decisions. Employees should be aware that employer contributions will increase their taxable income, but will not be subject to income tax withholdings.
- Monitoring Changes. The tax treatment of retirement contributions is subject to legislative updates. Employers should stay informed about potential changes and be ready to adjust their plans if needed.
Roth contributions can be a valuable employee benefit, offering employees greater flexibility in their retirement savings strategies, but they also introduce new tax, compliance, and implementation challenges that businesses must address. As with any strategic benefits decision, business owners and financial decision-makers should consult with their tax professionals to determine whether Roth contributions align with their financial and workforce goals.
Please contact us if you have any questions about employer Roth contributions or other compensation and benefits strategies.
