Bulletins

Designated Roth Accounts - an Option Worth Considering

by Daniel A. Kosmatka, CPA, PFS, CFF, CGMA

Dear clients and friends,

More and more employer retirement plans are allowing employees the option of making elective contributions to Designated Roth Accounts (DRAs). For employees with this option, it's worth considering, especially if contributions to Roth IRAs are not available because of income limitations.

What Is a DRA?

An employer retirement plan that allows employee elective contributions [e.g., a 401(k) plan] may include DRAs as part of the plan. Unlike employer contributions and pre-tax employee elective deferrals (which are excluded from the employee's taxable income), contributions to DRAs are currently includible in gross income. However, a qualified distribution from a DRA is free of federal income tax.

DRA contributions are employee elective contributions that are: (1) irrevocably designated by the employee at the time of the contribution election as Roth contributions; (2) treated by the employer as wages and included in the employee's income at the time of the contribution; and (3) maintained in a separate account.

DRAs are only available if they are provided for in the plan document. DRA contributions generally are subject to all of the same requirements that apply to regular pre-tax elective deferral contributions. The funds must be maintained in separate accounts that can be rolled over to either a Roth IRA or another qualified plan that allows for Roth contributions.

After-tax DRA Contribution vs. Pre-tax Elective Deferral

The following general principles should be considered when considering when an after-tax DRA contribution may be preferable to a pre-tax elective deferral.

  • Assuming that the participant will contribute the same amount to either the DRA or pre-tax elective deferral (i.e., the additional current taxes resulting from the DRA contribution are paid with outside funds), the longer the period the funds will be invested, the more beneficial the deferral and tax-free distribution advantages of the DRA. In the long term, a taxpayer will accumulate more after-tax income under a DRA than a pre-tax elective deferral account. The shorter the period the funds will be invested, the more beneficial the immediate tax savings advantage of the pre-tax elective deferral.

Note: DRA contributions can be particularly attractive for young taxpayers who can take advantage of a long tax-free compounding period-if they can get past the currently taxable hurdle.

  • A taxpayer, who expects to be in a higher tax bracket at retirement than today would favor a DRA with its tax-free withdrawals at retirement, while an individual who expects to be in a lower tax bracket at retirement would favor an elective deferral with its current deduction at today's higher tax rate.
  • A DRA may be preferable for taxpayers currently in a low tax bracket who anticipate remaining so in the future. They will realize little or no immediate tax savings from making a pre-tax elective deferral.

Designated Roth Accounts vs. Roth IRAs

The differences between DRAs and Roth IRAs are summarized in Exhibit 1. Assuming the taxpayer has the option of contributing to a DRA and/or Roth IRA, DRAs have some significant advantages including the following:

  • DRAs have no income limit that would restrict a plan participant from making a contribution. This makes them attractive to higher income individuals. Roth IRA contributions are not allowed for 2013 once the individual's modified AGI exceeds $188,000 if married filing joint, $127,000 if unmarried, or $10,000 if married filing separately.
  • Larger contributions can be made to a DRA (up to $17,500 for all DRA contributions and pre-tax elective deferrals in 2013; $23,000, if age 50 or older by the end of the year). This can be advantageous to both higher and lower income individuals (assuming they can afford a larger contribution). For 2013, Roth IRA contributions are limited to $5,500 ($6,500 if age 50 or older by the end of the year).

Observation: An individual's elective deferral and IRA contribution limits are computed separately. This means that an individual can potentially contribute the maximum contribution to both---for a total contribution as high as $23,000 ($29,500 for someone age 50 or older by the end of the year). However, the stars would have to be perfectly aligned for this to happen---the individual would have to have AGI under the Roth IRA contribution threshold, have the financial wherewithal to make the contributions, and be eligible to make a DRA contribution at work. Not too likely.

  • An employer can make matching contributions on employee DRA contributions. However, only an employee's DRA contributions can be allocated to the DRA. The matching contributions made on account of DRA contributions must be allocated to a pretax account, just as matching contributions are on pretax elective contributions.

Tip: If a taxpayer has the option of contributing to a 401(k) plan where the employer matches employee contributions, it generally pays for the taxpayer to make 401(k) contributions to the extent needed to get a full employer match before putting money into any kind of IRA. DRAs provide another option for saving with many of the same advantages as a Roth IRA and, at the same time, obtaining the employer match.

Exhibit 1

Differences between Designated Roth

Accounts (DRAs) and Roth IRAs

Item

DRA

Roth IRA

2013 annual contribution limit?

$17,500 ($23,000 if age 50 or older by year-end)

$5,500 ($6,500 if age 50 or older by year-end)

AGI limit on eligibility to make contributions?

No

Yes

Can contributions to the account be recharacterized?

No

Yes

What triggers required minimum distributions?

Reaching age 70Y21

Account owner's death

How is basis allocated to distributions?

Pro rata for each DRA

Total basis in all Roth IRAs withdrawn before earnings

How is five-year holding period (for qualified distribution status) applied?

To each DRA separately2

To all Roth IRAs combined3

Do qualified distributions include those made to pay first-time homebuyer costs?

No

Yes

1Or retirement from employer, if later but only if not a 5% owner.

2 Beginning on the first day of the year for which the first contribution is made to the DRA (except in the case of a direct rollover from another DRA, in which case the five-year period begins based on that DRA, if earlier).

3 Beginning on the first day of the first year for which a contribution is made to any Roth IRA.


On the other hand, Roth IRAs have some advantages over DRAs, not the least of which is that the individual controls the Roth IRA-if and where it is set up, how funds are invested, and when distributions are made. The DRA has to part of an employer retirement plan and, as such, is subject to the plan's distribution restrictions. Also, the employee is at the employer's mercy as to whether DRAs will be offered. Other advantages include:

  • Roth IRAs are not subject to the minimum distribution rules until after the owner's death. This favors wealthy individuals who don't need the funds for retirement and want to maximize amounts left to their heirs. Distributions from DRAs must start when the participant turns age 70 ½.

Note: The DRA can be rolled over to a Roth IRA to avoid the lifetime distribution requirement.

  • Distributions can be made from a Roth IRA at any time and amounts are considered to come first from Roth IRA contributions. So, nonqualified distributions are not taxable until all contributions made to all of the owner's Roth IRAs have been withdrawn. This favors all taxpayers. DRAs generally cannot be distributed until the participant separates from service with the employer or reaches age 59 ½. Also, contributions and earnings are considered to be distributed prorate.

In-plan Roth Rollovers

A 401(k) plan that includes DRAs may allow for a rollover from the portion of the plan that is not a DRA to the DRA maintained under the same plan for the benefit of the same taxpayer. This is called an in-plan Roth rollover. The rollover may be accomplished by a direct rollover (an in plan Roth direct rollover) or by a distribution of funds to the individual who then rolls over the funds into his DRA under the plan within 60 days (an in-plan Roth 60-day rollover).

Tax Consequences of In-plan Roth Rollovers. An in-plan Roth rollover is not tax-free. The taxable amount is the amount that would be includible in the participant's income if the rollover were made to a Roth IRA (the distribution's FMV reduced by any basis the participant has in the distribution).

Caution: The recharacterization rules do not apply to in-plan Roth rollovers so a participant cannot later undo an in-plan Roth rollover, as can be done with rollovers from traditional IRAs to Roth IRAs.

The 10% penalty tax on early withdrawals does not apply to amounts rolled over to a DRA in an in-plan rollover. However, individuals who take a distribution from a DRA within the five-year period starting with the first day of the tax year in which they rolled over an amount to that DRA may be subject to the 10% penalty tax on early distributions.

Amount Eligible for In-plan Roth Rollover. Any of the participant's vested amounts (other than amounts held in a DRA) are eligible for an in-plan Roth rollover to a DRA in the same plan.

Tip: Before 2013, only amounts that could otherwise be distributed from the plan qualified for an in-plan Roth rollover. This prevented many individuals, particularly those still working for the employer and under age 59 ½, from being able to roll over any part of their account. Starting in 2013, however, an employer plan with DRAs can permit an in-plan Roth rollover for an amount not otherwise distributable at the time of the rollover. This includes amounts in an individual's 401(k) pre-tax elective deferral account that are not distributable until the individual separates from service or reaches age 59 ½.

Conclusion

59 ½ Employees who have the option of having their 401(k) plan elective contributions made to a DRA may find this option worth considering, especially where contributions to Roth IRAs are not available because of the AGI threshold. Of course, they'll have to get over the hurdle that the DRA contribution is currently taxable. An in-plan rollover to a DRA is also worth considering. However, keep in mind that the recharacterization rules do not apply to in-plan Roth rollovers, so an in-plan Roth rollover cannot be undone.

If you have any questions or are interested in more information, please contact our office.

Very truly yours,

Daniel A. Kosmatka, CPA, PFS, CFF, CGMA
Dennis W. Donnelly, CPA, PFS
Michael R. Gohde, CPA, PFS