Small Business Roth 401k: Rules and Setup
Gain clarity on the structure and responsibilities of offering a Roth 401(k) to help you provide a valuable, tax-advantaged retirement benefit.
Gain clarity on the structure and responsibilities of offering a Roth 401(k) to help you provide a valuable, tax-advantaged retirement benefit.
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 Its primary appeal is that both contributions and their investment earnings can be withdrawn completely tax-free in retirement, provided certain conditions are met.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.
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.
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:
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.
Operating a 401(k) plan involves several ongoing administrative duties for the business or its TPA.