Late last year, the Internal Revenue Service (IRS) issued final regulations on Roth 401(k)s. These regulations clarify the rules under which 401(k) (and also 403(b)) plans may, beginning in 2006, allow participants to elect to have some or all of their deferral contributions treated as after-tax "designated Roth contributions." The IRS made few changes from the proposed regulations it issued earlier last year. To assist employers, the IRS has also posted a list of frequently asked questions and other informal guidance for employers on its web site. It also recently issued proposed regulations on the taxation of distributions from Roth 401(k)s.
Beginning this year, a 401(k) plan may permit an employee who makes elective contributions to irrevocably designate some or all of his or her contributions as designated Roth contributions. Unlike pre-tax contributions, designated Roth contributions are currently includible in the employee's gross income. However, a subsequent qualified distribution of designated Roth contributions will be excludable from the employee's gross income. Like Roth IRAs, plan participants can now benefit from tax-free build-up on their designated Roth contributions to their retirement accounts.
Designated Roth Contributions
The final regulations clarify that a plan cannot provide for designated Roth contributions unless it also offers pre-tax elective contributions. The Roth contributions must also be maintained by the plan in a separate account. The regulations provide additional and long-needed clarification regarding the separate accounting requirements, which will be important to record keepers. These clarifications include having a designated Roth contribution account and allocating gains, losses, and other credits or charges (but not forfeitures) on a reasonable and consistent basis to the designated Roth contribution account. Under the final regulations, no contributions other than designated Roth contributions and permitted rollover contributions may be allocated to a designated Roth account. For example, matching contributions may not be allocated to a designated Roth account. These separate accounting requirements continue until the designated Roth contribution is distributed.
Designated Roth contributions must satisfy certain requirements that apply to other elective contributions. For example, they are subject to the same nonforfeitability rules and distribution restrictions as pre-tax deferrals. The nondiscrimination test for the average deferrals of highly and nonhighly compensated employees will be applied to the designated Roth contributions. Roth contributions can qualify as catch-up contributions for eligible participants who are 50 years of age or older. Loans may be made from the designated Roth contribution account, if permitted under the plan. A direct rollover from a designated Roth account may only be made to another designated Roth account or to a Roth IRA.
Designated Roth contributions will be treated differently in a few respects than Roth IRA contributions. A participant may make designated Roth contributions regardless of his or her adjusted gross income whereas an individual's allowable annual contribution to a Roth IRA phases out ratably based on adjusted gross income. However, while a traditional IRA may be converted to a Roth IRA, pre-tax contributions to a plan cannot be converted to Roth contributions. Roth IRAs are subject to specific ordering rules to determine whether a distribution is treated as coming from a regular contribution, a rollover, or from other income; these ordering rules do not apply to designated Roth contributions. Designated Roth accounts are subject to the age 70½ required minimum distribution rules in the same way as pre-tax elective contributions; however, a regular Roth IRA is not subject to these rules.
Designated Roth contributions are subject to a 5-year holding period. A qualified distribution from a designated Roth account is one made after the five-tax-year period beginning with the first tax year for which the taxpayer contributed to the plan's designated Roth account established for the taxpayer and is made on or after attaining age 59½, at or after death (to a beneficiary or estate), or on account of disability.
Plan documents will need to be amended to provide for designated Roth contributions by the end of the plan year in which the Roth contributions are first effective, and election forms will need to be revised so that participants may designate whether their contributions are pre- or post-tax.
Taxation of Distributions
The recently issued proposed regulations are designed to clarify certain aspects of taxation related to designated Roth accounts including the taxation of nonqualified distributions and separate accounting requirements. As a general matter, Roth 401(k)s follow the rules regarding distributions and rollovers applicable to tax-qualified plans. If a distribution is not qualified, the distribution is taxed on the income earned on the account but not on the investment in the account (the basis). However, as noted above, nonqualified distributions do not follow the Roth IRA ordering rules, which consider the nontaxable basis first and then the taxable earnings on the basis. For example, if an employee's account in a Roth 401(k) contained $9,400 of designated Roth contributions and $600 of earnings and the employee takes a nonqualified distribution of $5,000, the distribution would consist of $4,700 of nontaxable Roth contributions and $300 of taxable earnings. As a final matter, the IRS notes that the reporting and recordkeeping requirements for Roth 401(k)s do not become effective until the beginning of the 2007 tax year.
If you need any assistance with your plan documents or have any questions about Roth 401(k)s generally, please contact one of the attorneys on the Employee Benefits and Executive Compensation Team listed below:
B. David Joffe
Gordon Earle Nichols
John M. Scannapieco