Small Business Roth 401k: Rules and Setup

A Roth 401(k) is a feature that can be added to a standard 401(k) retirement plan. Its primary appeal is that both contributions and their investment earnings can be withdrawn completely tax-free in retirement, provided certain conditions are met. For a small business, offering a Roth 401(k) option can enhance the appeal of its benefits package and can be included when a plan is first established or added to an existing one.

Core Plan Features and Rules

Employee contributions to a Roth 401(k) are made on a post-tax basis, meaning they are deducted from payroll after income taxes have been withheld. The Internal Revenue Service (IRS) sets annual limits on how much an employee can contribute. For 2025, the employee deferral limit is $23,500. Employees age 50 or over are permitted to make additional “catch-up” contributions of $7,500. A special, higher catch-up limit of $11,250 applies to those aged 60, 61, 62, and 63, if the plan allows. These limits apply to the combined total of an employee’s traditional and Roth contributions.

While employee Roth contributions are post-tax, any contributions made by the employer, such as matching funds or profit sharing, are always made on a pre-tax basis. The business can claim a tax deduction for these contributions. The employee does not pay taxes on the employer funds when contributed, but will owe income tax on both the employer contributions and their earnings upon withdrawal.

The main advantage of a Roth 401(k) is the potential for tax-free withdrawals, but this is contingent on the distribution being “qualified.” For a withdrawal to be qualified, it must meet two tests. First, the participant must satisfy the 5-year rule, which requires five years to have passed since their first Roth contribution. Second, the participant must have reached age 59½, become permanently disabled, or died.

Vesting schedules determine when an employee gains full ownership of the employer’s contributions. An employee’s own contributions are always 100% theirs immediately. Employer-provided funds may require an employee to work for a certain period, often between two to six years, to gain full ownership. If an employee leaves before being fully vested, they forfeit the unvested portion of the employer’s contributions.

As of 2024, Roth 401(k) accounts are no longer subject to Required Minimum Distributions (RMDs) for the original account owner. This change aligns their treatment with Roth IRAs, meaning funds can remain in the account for the owner’s entire lifetime.

Information and Decisions for Plan Setup

When establishing a plan, a business owner must make several decisions that are formalized in a legal document called the Plan Adoption Agreement. Key decisions include:

• Selecting a plan provider by evaluating administrative fees, the range of investment options, and the level of support provided. Providers range from large financial institutions to specialized third-party administrators (TPAs).
• Defining who is eligible to participate in the plan. Federal rules allow employers to set minimum requirements based on age and service, such as being 21 years old with one year of service.
• Deciding on the formula for employer contributions. A common approach is a matching contribution, while another option is a non-elective contribution made to all eligible employees. Adopting a “safe harbor” plan design, which requires specific employer contributions, can relieve the business from complex annual nondiscrimination testing.
• Choosing other plan features, such as an automatic enrollment feature, whether to permit loans against a 401(k) balance, and whether to allow for hardship withdrawals under specific IRS circumstances.

The Plan Setup and Activation Process

Once decisions are finalized, the business owner must sign the Plan Adoption Agreement and any other required paperwork to officially establish the retirement plan. A trust must also be established to hold the plan’s assets, ensuring they are kept separate from the company’s business assets and used solely for the benefit of participants. The plan provider typically arranges for the creation of this trust account.

With the plan legally established, all eligible employees must be notified and provided with a Summary Plan Description (SPD). The SPD is a document that explains how the plan works, what benefits it provides, and how to enroll. Enrollment forms and instructions on how to select investments must also be distributed.

The final activation step is coordinating with the company’s payroll system. A process must be put in place to accurately deduct employee contributions from their paychecks and transmit both employee and employer contributions to the plan’s trust account in a timely manner.

Ongoing Administrative Duties

Operating a 401(k) plan involves several ongoing administrative duties for the business or its TPA.

• All contributions must be deposited in a timely manner. Employee deferrals must be deposited into the plan’s trust as soon as they can be segregated from company assets. Employer contributions must be deposited by the date specified in the plan document.
• For plans without a safe harbor design, annual nondiscrimination testing is required. These tests, known as the Actual Deferral Percentage (ADP) and Actual Contribution Percentage (ACP) tests, ensure the plan does not unfairly favor highly compensated employees.
• Most 401(k) plans with 100 or more participants must file an annual report with the federal government, known as Form 5500. This form details the plan’s finances, operations, and compliance, and is typically due the last day of the seventh month after the plan year ends.
• Regular notices must be provided to all plan participants. These include an annual fee disclosure, a safe harbor notice if applicable, and a Summary Annual Report, which is a condensed version of the Form 5500 information.
• Meticulous records must be maintained for each participant, tracking all contributions, distributions, investment earnings and losses, and loan activity. These records are essential for government filings, compliance tests, and ensuring participants receive correct benefits.