On March 2, 2005, the Internal Revenue Service published proposed amendments to the regulations under sections 401(k) and (m) of the Internal Revenue Code (the “Code”). The proposed regulations provide guidance concerning the requirements that must be met for a contribution to be a designated Roth contribution under Code section 401(k).
Section 402A, added to the Code by the Economic Growth and Tax Relief Reconciliation Act of 2001 (“EGTRRA”), provides that for taxable years after December 31, 2005, sponsors of 401(k) plans may implement “qualified Roth contribution programs” as part of their respective 401(k) plans.¹ These programs will permit participants to designate all or part of their elective deferrals as after-tax Roth contributions. Aftertax Roth contributions are not excludable from taxable income at the time the contribution is made, like a regular elective deferral. Like the Roth IRA, the earnings associated with the Roth contribution grow income taxfree, and the distributions from the designated Roth account are not subject to income tax. Unlike the Roth IRA, all participants of 401(k) plans that include a qualified Roth contribution program will be able to make after-tax Roth contributions to their accounts, regardless of their income levels.
Rules Relating to Designated Roth Contributions
Under the proposed regulations, designated Roth contributions under a qualified cash or deferred arrangement must be:
- Designated irrevocably by the employee making the contribution as a Roth contribution at the time of the deferral;
- Treated by the employer as includible in the employee’s income at the time the employee would have received the contribution amount in cash; and
- Maintained by the plan in a separate account.
The separate account is necessary for the plan to maintain a record of all contributions and distributions from the account. Gains, losses and other credits or charges must be separately allocated to the Roth contribution account on a reasonable and consistent basis. Forfeitures may not be allocated to a Roth contribution account. The separate account must be maintained from the time the contribution is made until the time the account is completely distributed.
Because designated Roth contributions are treated as elective deferrals, they must satisfy the other Code requirements applicable to elective deferrals. For example, designated Roth contributions are:
- subject to the annual dollar limit on deferrals ($15,000 in 2006) under section 402(g). This means that elective deferrals and designated Roth contributions are added together to determine this limit.
- combined with regular elective deferrals when applying the catch-up contribution limit; and
- included with regular elective deferrals for actual deferral percentage (“ADP”) testing.
Designated Roth contributions are 100% vested at all times and distributions may only be made upon termination of employment, death, disability, retirement, or (if permitted under the plan) attainment of age 59½ or hardship. Although distributions are permitted for the above events, tax-free treatment is only provided to “qualified distributions.” A qualified distribution is one that is made after age 59½, or on account of death or disability, and is made at least 5 years after the date the first designated Roth contribution was made (the “5–year aging rule”). A qualified distribution from a Roth 401(k) account may only be rolled over to another Roth 401(k) plan that accepts rollovers, or to a Roth IRA.
Under the proposed regulations, a plan that fails to satisfy the ADP test for any year may provide that an highly compensated employee (“HCE”) who has made both pre-tax contributions and designated Roth contributions to the plan during that year may elect whether the excess contributions distributed to the HCE will be attributed to the pre-tax contributions or the Roth contributions. A corrective distribution of excess contributions will not be includible in income to the extent that excess is attributed to Roth contributions. However, a distribution of earnings allocable to a corrective distribution of excess contributions that are Roth contributions will be includible in income.
The proposed regulations provide similar rules for correcting a plan’s failure to satisfy the actual contribution percentage (“ACP”) test. If designated Roth contributions are matched, a corrective distribution of excess aggregate contributions is not taxable (to the extent attributable to designated Roth contributions). Earnings allocable to such a distribution would be taxed in the same manner as earnings allocable to regular excess aggregate contributions.
Plans permitting Roth contributions must be amended to reflect the rules described in the proposed regulations. In addition, the plans must be amended to provide that amounts attributable to designated Roth contributions may be rolled over only to another plan maintaining a designated Roth contribution account or to a Roth IRA.
Issues Not Addressed by the Proposed Regulations
The preamble states that the proposed regulations do not provide guidance with respect to the recovery of an employee’s investment in the contract associated with designated Roth contributions. In the event that a distribution from a Roth contribution account is not a qualifying distribution (and, thus, not excluded from income), it is unclear how the distribution would be taxed. The IRS and Treasury Department request comments on the issues on which guidance is needed with respect to distributions.
The regulations are proposed to apply to plan years beginning on or after January 1, 2006.
Sponsors may want to assess whether the additional administrative costs of providing such deferrals, including possibly the modification of payroll systems, is outweighed by the benefits that this provision will provide their employees.
¹ Internal Revenue Code section 402A also provides that sponsors of 403(b) plans may implement “qualified Roth contribution programs” as part of their respective 403(b) plans. However, the proposed regulations apply only to 401(k) plans.