The Internal Revenue Service (IRS) gave plan sponsors an early Christmas gift with the release of new guidance late last year addressing several key provisions contained in SECURE 2.0. A welcome portion of the notice was further guidance on the new option allowing for participants in 401(k) and 403(b) plans to elect to receive employer matching and nonelective contributions on a Roth basis. A participant making this election would owe income tax on the contributions, but would avoid tax when they later withdraw the money as long as the distribution is a qualified distribution.
Prior to this release, there was little guidance on the implementation of this option, which made employers hesitant to adopt the provision. For example, one point of the bill that was left unclear, especially for employers who made contributions on a per payroll basis, was the frequency at which an employee could change their elections. Many worried that employees would be able to change their elections at any time, which in turn could lead to administrative headache. As part of the new guidance, the IRS has clarified that elections must be made no later than the date the contribution is allocated to the participant’s account and must be irrevocable. However, participants must only be given the effective opportunity to make or change Roth employer contribution elections at least once a plan year.
Additionally, the guidance explained that a matching contribution may be designated as a Roth contribution only if the employee is fully vested in matching contributions at the time the contribution is allocated to the employee’s account. Prior to this guidance, many employers with graded-vesting schedules questioned how they could permit Roth elections for partially vested participants. As part of the guidance the IRS clarified that because contributions must be fully vested, excluding partially vested employees from making the election would not be a discriminatory benefit feature.
In terms of taxation and reporting, the IRS noted that Roth employer contributions are income in the year in which the contribution is allocated to the individual’s account, and must be reported to the IRS on Form 1099-R, the same form that is used for distributions. The IRS further clarified that designated Roth matching contributions and nonelective contributions are not wages for purposes of federal income tax withholding including FICA and FUTA, even if a plan uses a safe harbor definition of compensation. However, for governmental plans, Roth nonelective contributions will be subject to social security and Medicare taxes because the contributions are fully vested, and do not have a substantial risk of forfeiture. Because these contributions are income, but not included in wages, Plan sponsors may want to advise employees that they might need to increase their withholdings to avoid additional tax payments come filing time.
While this guidance is welcome, Plan Sponsors who wish to adopt this provision should first have an in-depth conversation with their recordkeeper to ensure that their recordkeeping system has been updated to support this new option. If you decide to implement this option, your plan will have to be amended, but that amendment deadline was extended until December 31, 2026.
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