The Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) added a new Section 402A to the Internal Revenue Code (the “Code”) effective January 1, 2006, which provides that 401(k) and 403(b) plans may permit participants to designate some or all of their elective deferrals as Roth contributions. These “designated Roth contributions,” unlike pre-tax elective deferrals, are currently includable in income. In turn, “qualified distributions” of designated Roth contributions are excludable from gross income.
In two parts, this article is intended to cover everything you need to know about the Roth 401(k) and 403(b).¹ The first part of this article is directed towards those considering implementing the Roth 401(k) provisions. This section discusses what everyone wants to know—the pros and cons of adopting the Roth 401(k) provisions. Whether you are a plan sponsor or a participant you will be surprised to discover the significant financial value of Roth 401(k)s.
The second part of this article is more technical, and describes the current rules that govern Roth 401(k)s. This includes the tax consequences of contributions and distributions, the rollover rules, reporting requirements, etc. If you have already decided that the Roth 401(k) is in your best interest (or you have already adopted the Roth 401(k) provisions), this section will be a useful resource.
Part I: Why Your Business or Organization Must Have a Roth 401(k) Plan (maybe)
The reason plan employers should, and eventually will, adopt the Roth provisions is that Roth 401(k)s can be extremely valuable to plan participants. Roth 401(k)s permit plan participants to stash away significantly more money in a defined contribution plan than Code sections 402(g) or 415 currently permit for exclusively pre-tax arrangements.
The best explanation is by illustration. Assume a 50 year old participant will earn $100,000 in 2006 and, for the sake of simplicity, also assume the marginal tax rate for this participant is 50%. Let’s say the participant needs $80,000 for living expenses during the year ($40,000 after taxes) and intends to invest the $20,000 balance. If the participant’s plan does not offer the Roth option, the participant would be wise to invest the entire $20,000 as pre-tax contributions (the 2006 402(g) limit of $15,000 plus the 2006 catch-up limit $5,000). If the participant’s plan offered the Roth option, the participant could invest $10,000 under the Roth option ($20,000 pay less 50% in taxes equals $10,000).
As long as the participant’s marginal tax rate stays the same, the $20,000 pre-tax contribution is IDENTICAL in economic value to the $10,000 Roth contribution. For instance, assume that the participant’s investments return 10% in 2006. At the end of 2006, the $20,000 pre-tax contribution grows to $22,000, while the $10,000 Roth contribution grows to $11,000. If the participant takes a distribution of the Roth contribution on January 1, 2007, she will receive the $11,000 tax-free under the Roth rules (please assume for purposes of this illustration that the distribution is a qualified distribution). A distribution of the $22,000 from the pre-tax account on that date also yields $11,000 after applying the tax rate of 50%. The result is the same regardless of how long the contributions remain in the plan, as long as the tax rate stays the same.
Many practitioners argue that the Roth contribution is more valuable only if the participant’s marginal tax rate is greater at retirement than in the year of the contribution. For example, assume in our illustration that the participant’s marginal tax rate increased to 60% on January 1, 2007. The tax-free Roth distribution of $11,000 would be unaffected by the tax rate increase. However, a distribution of the $22,000 from the pre-tax account would yield only $8,800 to the participant. Conversely, if the tax rate decreased to 40%, the pretax contribution would be seen as a better bet because the participant would receive $13,200 from the pre-tax contribution instead of $11,000 from the Roth.
The overly simple conclusion being reached far and wide is that if you expect your marginal tax rate to increase at retirement, the Roth is your friend, and if you are expecting a decrease, the Roth is your foe.
Hogwash! The Roth Can Be Everybody’s Friend
For a moment, let’s go back to assuming that the tax rate in our illustration stays the same. In that case, we just proved that the financial benefit of a $20,000 pretax contribution is identical to a $10,000 Roth contribution. However, what additional opportunity does the Roth account provide? Eureka! Our participant has the opportunity to contribute an additional $10,000 to the Roth account using additional earnings or outside savings. Here’s the part most practitioners, service providers, plans and participants have not been alerted to: if $10,000 in Roth contributions are identical to $20,000 in pre-tax contributions, then $20,000 in Roth contributions are identical to $40,000 in regular pretax contributions! That amounts to a $20,000 increase in the Code section 402(g) limit. For 2006, the Code section 415 overall annual contribution limit is $44,000. By fully utilizing the Roth contribution as described above, the participant also has effectively increased the Code section 415 limit by $20,000, to $64,000. This participant may receive up to $24,000 in employer contributions in addition to the Roth contributions.
The secret of the value to making additional contributions to the plan with outside savings is that money inside a qualified-type retirement plan will always perform better than the same money outside the plan. That’s what we are really comparing here—after-tax money inside a plan against our savings outside a plan. At a minimum, your investments inside the plan are never subject to dividend or capital gains tax treatment.
Of course, the benefit under this demonstration is somewhat inflated by the use of a 50% tax rate. But for 2006, participants with a 35% or a 28% marginal tax rate in 2006 can contribute an extra $7,000 or $5,600, respectively. Again, these extra contributions represent an effective increase in the Code section 402(g) and 415 limits for these participants. By utilizing the opportunity to make additional Roth contributions, many participants can be better off economically even if their marginal tax rate decreases at retirement. For those whose marginal tax rate stays the same or increases at retirement, it’s a pure windfall.
More Benefits to Participants
Even participants who cannot utilize the opportunity to make the additional Roth contributions discussed above can benefit, by simply substituting their available Roth contributions for their pre-tax contributions, if they believe their marginal tax rate will increase at retirement. Likely candidates are participants at an early or middle stage in their careers who have a reasonable expectation that their annual income, and therefore their tax rate, will increase by the time they retire. For participants who may be less clear about their retirement strategy, the Roth offers an opportunity to hedge against the risk of escalating tax rates.
Last but not least, for those interested participants, the Roth offers a valuable estate planning opportunity not available with respect to pre-tax contributions. Roth contributions may be rolled over into a Roth IRA which, unlike a traditional IRA, is not subject to the minimum distribution requirements during the life of the IRA holder. Such a rollover can extend the period during which earnings on Roth contributions may accumulate tax free well beyond the time limit for deferring pre-tax contributions.
What’s the Catch?
Like many things in life, the benefits are not without cost. Potential employer costs include expenses associated with:
- Recordkeeping (separately tracking contributions);
- Payroll (software redesign and/or other system and documentation modifications);
- Administration (drafting applicable forms and implementing appropriate procedures);
- Communications (participant explanations, including drafting and distributing SPDs and/or SMMs); and
- Legal (drafting and adopting plan amendments).
If that weren’t enough for some employers to handle, under the so-called “EGTRRA Sunset,” the provisions of EGTRRA are scheduled to expire for years beginning after December 31, 2010. If the Roth provisions are not renewed, there may be additional costs associated with dismantling the entire process that could equal the costs of implementation.
There may also be some disadvantages to participants. Those who are fairly certain that their tax rate will be significantly lower at retirement, perhaps because they are nearing the end of their careers, may not benefit. Also, for participants who cannot make the additional Roth contributions discussed above because they wish to maintain their current take home pay, Roth contributions may result in lower matching contributions. For example, assume a 20% tax rate for a participant who will earn $50,000 in 2006. If he needs $45,000 in living expenses for the year, he can contribute $5,000 pre-tax or $4,000 as a Roth contribution ($5,000 less 20% is $4,000). If the contributions are matched at 50%, the pre-tax contributions garner the participant a $2,500 match, while the Roth contributions earn him only a $2,000 match. Moreover, the current deduction for pre-tax contributions is a “sure thing,” while there’s no guarantee that in the future Congress will not decide to tax distributions of Roth contributions (long ago, Social Security benefits were tax-free).
Although it appears that there are significant benefits associated with the Roth, a cost-benefit analysis must be performed when an employer considers implementing the Roth provisions, or when a participant considers making Roth contributions. Because each situation is unique, we strongly encourage employers and participants to discuss their situation with their tax and/or financial advisor before making any decisions concerning the Roth contributions. If you are an employer grappling with these issues give us a call and we will be glad to guide you through the analysis.
Part II: The Book on the Roth 401(k)
Roth 401(k) and 403(b) accounts are governed by Code section 402A, and the final and temporary regulations issued under that and related Code sections.
Code section 402A provides that:
- A participant’s designated Roth contributions (and any allocable earnings) must be maintained in a separate account (a “designated Roth account”) from the participant’s pre-tax contributions (and any allocable earnings) and separate recordkeeping must be maintained for each of the accounts;
- The Code section 402(g) limit for a year applies to the total of designated Roth contributions and pretax contributions. In 2006, the combined total of Roth and pre-tax contributions by a participant may not exceed $15,000 plus (if applicable) up to $5,000 in catch-up contributions;
- Eligible rollover distributions from a designated Roth account may be rolled over only to another designated Roth account or a Roth IRA;
- Only qualified distributions are excludable from income. These are distributions:
- made on or after the date a participant reaches age 59½;
- made on or after the participant’s death; or
- attributable to the participant being disabled.
Also, a qualified distribution may not be made before the earlier of the 5th taxable year of the participant following the participant’s first contribution under the plan or, if a Roth rollover contribution was made to the plan from a designated Roth account previously established for the participant under another plan, the first taxable year for which the participant made a designated Roth contribution to that previously established account. For example, if a participant makes his or her first designated Roth contribution under a plan in 2008, the earliest date a participant can receive a qualified distribution from that plan is January 1, 2013, unless the participant rolled over designated Roth contributions from another plan and those contributions were initially made before 2008. In that case, a qualified distribution may be made in the 5th taxable year following the taxable year in which the participant first made a Roth contribution to the plan from which the rollover originated; if the participant rolled over designated Roth contributions initially made in 2007, a qualified distribution could occur as early as January 1, 2012;
- Qualified distributions do not include distributions in excess of the 402(g) limit (a.k.a. excess deferrals) or distributions to highly compensated employees for the purpose of satisfying the ADP test (a.k.a. excess contributions), or any associated earnings;
- If any excess deferral attributable to a designated Roth contribution is not distributed on or before April 15th following the close of the taxable year in which that excess deferral is made, the excess deferral must be included in gross income for the taxable year in which the excess deferral is distributed. In other words, excess deferrals that are not timely distributed will be taxed twice; and
- Code section 72 must be applied separately with respect to distributions from a designated Roth account and other distributions from the plan.
2005 Final Regulations
On March 02, 2005, the IRS issued guidance on the Roth 401 rules in the form of proposed regulations. [See our May 2005 issue for an overview of the proposed regulations.] On December 30, 2005, the IRS issued final regulations on the requirements applicable to designated Roth contributions under a 401(k) plan (“final regulations”). The final regulations are consistent with, and clarify in small measure, the proposed regulations.
The final regulations maintain the general rules from the proposed regulations and provide that designated Roth contributions must be irrevocably designated as such, in lieu of pre-tax contributions, and treated as includable in gross income at the time the participant would have received cash but for the contribution election. The final regulations maintain the rule from the proposed regulations that permits a highly compensated employee with elective contributions for a year that include both pre-tax contributions and designated Roth contributions to elect whether excess contributions are to be attributed to the pre-tax contributions or designated Roth contributions. The final regulations also retain the rule that a distribution of excess contributions is not includible in gross income to the extent it represents a distribution of designated Roth contributions. However, the income (i.e., earnings) allocable to a corrective distribution of excess contributions that are designated Roth contributions is includible in gross income in the same manner as income allocable to a corrective distribution of excess contributions that are pre-tax contributions.
In addition, the final regulations clarify that:
- A plan may not be only a Roth 401(k) plan. Pre-tax contributions must be offered in a plan that provides for designated Roth contributions;
- No contributions other than designated Roth contributions, and rollovers of designated Roth contributions and Roth IRA contributions, may be allocated to a designated Roth account. For example, forfeitures, matching contributions and non-Roth rollovers may not be allocated to a designated Roth account;
- Eligible rollover distributions of amounts from a designated Roth account may only be rolled into another designated Roth account in a 401(k) plan, a 403(b) plan or a Roth IRA. (However, certain rollovers from Roth 401(k)s to 403(b)s (and vice-versa) are impermissible under the later 2006 proposed regulations. See the discussion below.);
- A plan may treat the balance of a participant’s Roth contribution account and the participant’s other accounts as separate plans for purposes of the $200 de minimus rollover rule. This rule provides that a plan will satisfy the rollover requirements even if the plan administrator does not permit a participant to elect direct rollovers for distributions during a year that are reasonably expected to total less than $200;
- Participants must be permitted to elect or change an election to make designated Roth contributions at least once during each plan year; and
- If a plan provides for automatic enrollment (a.k.a. “negative elections”), the plan must provide the extent to which the default contributions are either pretax contributions or designated Roth contributions.
The preamble to the final regulations adds the following:
- Because designated Roth contributions must satisfy the requirements applicable to pre-tax contributions under a 401(k) plan, designated Roth contributions:
- are subject to the noforfeitability and distribution restriction provisions applicable to pre-tax contributions;
- must be taken into account for purposes of the ADP test;
- may be treated as catch-up contributions; and
- may be the source of loans and hardship distributions;
- Designated Roth accounts in 401(k) plans are subject to the minimum distribution rules in the same manner as pre-tax contributions despite the fact that Roth IRAs are not subject to the minimum distribution rules while the IRA owner is alive; and
- Plans are permitted but are not required to allow participants to elect the extent that distributions will be made from their designated Roth account or other accounts.
The final regulations are generally applicable for plan years beginning on or after January 1, 2006.
2006 Proposed Regulations
On January 26, 2006, the IRS issued proposed regulations (mostly in Q&A format) concerning:
- the taxation of disqualifying distributions from designated Roth accounts (i.e., distributions before the earliest of age 59½, death or disability, and satisfaction of the five-taxable-year rule discussed above);
- the reporting and recordkeeping requirements with respect to these accounts;
- the interaction of Code sections 408A (governing Roth IRAs) and 402A;
- amounts that cannot be qualified distributions, distribution of employer securities and related matters; and
- designated Roth contributions under 403(b) plans.
TAXATION OF DISQUALIFYING DISTRIBUTIONS AND RELATED ISSUES
The proposed regulations make clear that designated Roth contributions are treated as a separate contract under the rules of Code section 72 and disqualifying distributions are taxed in accordance with the rules under Code section 72. As a result, the portion of any distribution that is includible in income as an amount allocable to income on the contract and the portion not includible in income as an amount allocable to investment in the contract (basis) are determined in the same proportion that designated Roth contributions and earnings bear to the total designated Roth account in the plan. For example, if a participant has $20,000 in her designated Roth account consisting of $15,000 of designated Roth contributions and $5,000 of earnings, a disqualifying distribution of $8,000 would consist of $6,000 of designated Roth contributions that would not be includible in income and $2,000 of earnings that would be includible in income.
In addition, a participant may have only one separate contract for purposes of Code section 72 under a plan. However, additional separate accounts may be established for an alternate payee under a QDRO or different beneficiaries after the death of a participant.
Rollover of Designated Roth Contributions
- If any portion of an eligible rollover distribution from a designated Roth account in a 401(k) plan is not taxable (without regard to any rollover) a rollover may be accomplished only through a direct rollover. Moreover, such direct rollover MUST be made to another qualified plan—not a 403(b) plan—which agrees to separately account for the non-taxable amount.
- If a distribution from a designated Roth account is made directly to a participant, the participant may not rollover any portion of the distribution that is not taxable to another 401(k) plan (or 403(b) plan). However, the participant is permitted to rollover all or a portion of such a distribution to a Roth IRA within the 60-day period for completing a non-direct rollover. The income limits applicable to Roth IRAs do not apply for these purposes. If only a portion of this distribution is rolled over, the portion that is not rolled over is treated as first consisting of amounts that are taxable.
- Alternatively, the participant may rollover the taxable portion of such a distribution (without regard to the rollover) in a non-direct rollover to a designated Roth account under another 401(k) plan or 403(b) plan within the applicable 60-day window. The participant’s period of participation is not carried over for purposes of the 5-taxable-year period requirement for qualified distributions under the recipient plan. See also the special reporting requirement, below.
REPORTING AND RECORDKEEPING REQUIREMENTS
- The plan administrator or another appropriately delegated responsible party must keep track of the 5-taxable-year period and the amount of designated Roth contributions for each participant.
- In the case of a direct rollover, the distributing plan must provide the recipient plan with a statement noting the first year of the 5-taxable-year period and the amount of the non-taxable portion of the distribution, or that the distribution is qualified.
- In the case of a distribution directly to the participant, a statement must be provided to the participant upon request noting the amount of the nontaxable portion of the distribution or that the distribution is qualified.
- Such statements to a recipient plan or participant must be provided within a reasonable period of time (but no later than 30 days) following the direct rollover or participant request.
- A recipient plan (and presumably a participant) may rely on these statements.
- As noted above, a special reporting requirement applies to the extent a participant rolls over the taxable portion of such a distribution (without regard to the rollover) in a non-direct rollover to a designated Roth account under another 401(k) plan or 403(b) plan. In this case, the recipient plan must notify the IRS of the acceptance of the rollover contribution. This notice must be sent to an address the IRS will provide in future guidance and must include:
- The participant’s name and social security number;
- The amount rolled over;
- The year the rollover was made; and
- Any other information requested in future guidance.
- Any transaction or accounting methodology that has the effect of directly or indirectly transferring value from another account in the Plan into the designated Roth account violates the separate accounting requirement. For example, a plan may not allocate all the earnings under the plan for the year to the Roth account.
ADDITIONAL ISSUES CONCERNING ROTH IRAS:
- An individual may establish a Roth IRA for the purpose of rolling over an eligible rollover distribution from a designated Roth account even if the individual is not otherwise eligible (because of income limitations) to make contributions to a Roth IRA.
- The 5-taxable-year period for qualified distributions from a designated Roth account and qualified distributions from a Roth IRA are determined independently. As a result, the date contributions were first made to a designated Roth account does not count toward determining the 5-taxable-year period under a Roth IRA that has accepted a rollover from the designated Roth account. The 5-taxable-year period under a Roth IRA is based only on the date the first contribution is made by an individual to any Roth IRA.
- Nonetheless, the 5-taxable-year period for Roth IRAs has little impact on the non-taxable portion of any distribution from a designated Roth account that is rolled over into a Roth IRA. That is because the non-taxable portion of such a rollover is treated as return of investment in the contract under the Roth IRA (i.e., treated as a regular Roth IRA contribution), which is distributable tax free before any taxable distributions. Accordingly, the 5-taxable-year period for Roth IRAs would have no relevance with respect to the amount of a qualified distribution from a designated Roth account that is rolled over to a Roth IRA. Of course the tax consequences of any earnings on such rolled over amount would be governed by the 5-taxable-year period for Roth IRAs.
- Similarly, the impact of the 5-taxable-year period rule under designated Roth accounts can be avoided by rolling over designated Roth account distributions to a Roth IRA where the participant has already satisfied the rule for qualifying distributions from a Roth IRA. For example, if a participant receives an eligible rollover distribution from a designated Roth account after age 59½ but before the expiration of the 5-taxable-year rule for qualified distributions under the plan, and rolls over the distribution to a Roth IRA account that has satisfied the 5-taxable-year rule for Roth IRAs, then the amount rolled in (plus earnings) would not be includable in income when distributed from the Roth IRA.
- A distribution from a Roth IRA cannot be rolled over into a designated Roth account—regardless of whether any or all contributions to the Roth IRA were rolled over from designated Roth accounts.
AMOUNTS THAT CAN NOT BE QUALIFIED DISTRIBUTIONS:
Certain kinds of distributions that are described in Treasury Regulation section 1.402(c)-2, A-4, are not eligible rollover distributions. Because these amounts must be currently included in income when distributed, the proposed regulations provide that these amounts cannot be qualified (tax-free) distributions from a designated Roth account. These amounts include:
- Distributions of elective deferrals in excess of the Code section 415 limits (and related earnings);
- Distributions of excess deferrals (and related earnings);
- Distributions of excess contributions and excess aggregate contributions (and related earnings);
- Deemed distributions of participant loans;
- Dividends paid on employer securities under Code section 404(k) (other than dividends reinvested under Code section 404(k)(2)(A)(iii)(II)); and
- The costs of life insurance coverage (P.S. 58 costs).
DISTRIBUTION OF EXCESS DEFERRALS AND GAP INCOME:
- Excess deferrals exceeding the Code section 402(g) limit can be distributed tax-free on or before April 15th of the year following the year the excess deferrals were made. If the excess deferrals are not distributed by April 15th, the excess deferrals are includible in income without regard to any exclusion for basis under Code section 72 (and are not eligible for rollover, as noted above).
- The gap period income rules apply equally to excess deferrals of pre-tax and designated Roth contributions.
DISTRIBUTION OF EMPLOYER SECURITIES
- If a distribution of employer securities from a designated Roth account is not a qualified distribution, net unrealized appreciation is not includible in gross income (unless the participant elects otherwise), is not included in the basis of the distributed securities, and is capital gain to the extent realized upon a subsequent transaction.
- If the distribution is qualified, the basis in the distributed securities is the fair market value at the time of the distribution.
DESIGNATED ROTH ACCOUNTS UNDER SECTION 403(B) PLANS:
- Under the proposed regulations, designated Roth contributions and accounts under 403(b) plans generally operate in the same manner as these contributions and accounts under 401(k) plans. For instance, if any portion of an eligible rollover distribution from a designated Roth account in a 403(b) plan is not taxable (without regard to any rollover) a rollover may be accomplished only through a direct rollover. Plus, such direct rollover MUST be made to another 403(b) plan—not a qualified plan—which agrees to separately account for the non-taxable amount.
- In addition, the 403(b) plan universal availability requirement includes the right to make designated Roth contributions.
The 2006 proposed regulations are generally effective for taxable years beginning on or after January 1, 2007. However, many of the provisions are proposed to be effective for taxable years beginning on or after January 1, 2006, including the prohibition against transferring value between designated Roth accounts and other accounts under a plan, the rules relating to excess deferrals, the rollover rules, and the rules relating to Roth IRAs. The rules under 403(b) will likely be effective January 1, 2007, but no earlier than the date the 2004 proposed regulations under Code section 403(b) are finalized. Most importantly, plans and participants are authorized to rely on the proposed regulations.
Note: Under Notice 2005-95, the deadline to adopt an amendment implementing designated Roth contributions is the end of the plan year in which the plan amendment is effective.
If you have any questions about these rules, or the manner in which a plan may be amended to incorporate the Roth provisions, give us a call and we would be glad to assist you.
¹ Although this article discusses the Roth primarily in terms of the 401(k) plan, the Roth 401(k) and 403(b) are very similar. The few differences between them are discussed in the second section of this article.