Roth 401(k) plan provisions under Internal Revenue Code (the “Code”) section 402A, enacted as part of the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), first became effective on January 1, 2006. Participants in a 401(k) plan that has adopted the Roth provisions may elect to contribute after-tax dollars into the plan and, if certain requirements are met, may receive a tax-free distribution of their contributions and earnings at retirement or termination of employment.
Proposed regulations regarding Roth contributions were issued on May 2, 2005. [See our May 2005 issue for an overview of the proposed regulations.] On December 30, 2005, these regulations were issued by the Internal Revenue Service (the “IRS”) in final form. The 2005 regulations addressed certain basic rules regarding Roth 401(k) contributions, but did not provide guidance concerning the taxation of Roth contributions. On January 26, 2006, the IRS issued a second round of proposed regulations regarding Roth 401(k) contributions, which addressed:
- the taxation of disqualifying distributions from Roth accounts;
- 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
- Roth contributions under 403(b) plans.
For our February 2006 issue, I wrote an article entitled The Book on the Roth 401(k) and 403(b) and Why Your Business or Organization Must Have One (maybe), in which I lauded the value and explained the advantages for participants of making Roth contributions to a 401(k) plan. I also noted in that article that some employers were hesitant to implement the Roth provisions due to the expected expiration of the Roth 401(k) rules for years beginning after December 31, 2010 (the so-called “EGTRRA Sunset”). However, after the publication of that article, the Pension Protection Act of 2006 made the Roth 401(k) rules “permanent.” The February 2006 article also contains a comprehensive explanation of the statutory rules, the 2005 final regulations and the 2006 proposed regulations.
On April 30, 2007, the IRS published the final version of the 2006 proposed regulations. These 2007 final regulations do not include guidance provided under the proposed regulations for 403(b) plans. This guidance will be issued separately under 403(b) final regulations.
2007 Final Regulations
The 2007 final Roth 401(k) regulations generally adopt the provisions of the 2006 proposed regulations with the following clarifications (and some modifications):
- In the case of a distribution to an alternate payee or beneficiary, the age, death or disability of the participant is used to determine whether the distribution is qualified. However, in the case of a rollover by an alternate payee or spousal beneficiary to a Roth account under his or her employer’s plan, the age, death or disability of such individual is used to determine whether a distribution from the recipient plan is qualified.
- Roth contributions made by a reemployed veteran are treated as made in the taxable year to which the contributions relate, as designated by the reemployed veteran. In the absence of any designation, for purposes of determining the first year of the five years of participation, the contribution is treated as made in the veteran’s first taxable year in which the veteran’s qualified military service begins, or if later, the first taxable year in which Roth contributions could be made under the plan.
- The 5-taxable-year period of participation will not be triggered by excess contributions that are distributed to prevent an ADP failure, contributions returned to the employee in connection with an eligible automatic contribution arrangement, or a year in which the only contributions consist of excess deferrals.
- The basis recovery rules applicable to Roth IRAs (basis first) under Code section 408A do not apply to distributions from a Roth account in a 401(k) plan.
- The requirement that the receiving plan in a rollover separately account for rolled over Roth contributions has been eliminated.
- For purposes of applying the rollover ordering rules under Code section 402(c)(2), any amount of a Roth account in a 401(k) plan that is paid as a direct rollover is treated as a separate distribution from any amount paid directly to the distributee.
- A distribution from a Roth account may only be rolled over to a 401(k) plan or 403(b) plan if that plan contains Roth provisions.
- If the entire account balance of a Roth account is rolled over to another Roth account and, at the time of the distribution, the investment in the contract exceeds the balance in the Roth account, the investment in the contract in the distributing plan is included in the investment in the contract of the recipient plan (subject to a potential deduction upon subsequent distribution under Revenue Ruling 72–305).
- An indirect rollover of the taxable portion of a Roth account starts the 5-taxable-year period of participation under the receiving plan for a participant who has made no prior Roth contributions to that plan.
- Hardship distributions, minimum required distributions and certain periodic payments are not precluded from being qualified Roth distributions simply because they are not eligible for rollover.
- In the case of a distribution of an annuity contract from a Roth account, the determination of whether a distribution is a qualified or nonqualified distribution is made at the time of a distribution from the contract.
- If any portion of a distribution that is includible in income (determined without regard to the rollover) is rolled over to a Roth account by the distributee rather than by direct rollover, the plan administrator of the recipient plan must notify the IRS of its acceptance of the rollover contribution. Nonetheless, no reporting is required until relevant IRS “Forms and Instructions” are issued.
- If any excess deferrals that are Roth contributions are not corrected before April 15th of the year following the excess, the first amounts distributed from the Roth account are treated as distributions of excess deferrals and earnings until the excess deferrals (and related earnings) are distributed.
- The gap period income rule applies to both pre-tax and Roth excess deferrals.In addition, the 2007 final Roth regulations clarify (and modify) the 2005 final regulations as follows:
- The balances of a participant’s Roth account and a participant’s other accounts under the plan are treated as held under two separate plans for purposes of the $200 de minimus rollover rule, the automatic rollover rules, and the split rollover distribution rules under Treasury Regulation section 1.401(a)(31)–1; Q&A 9 and 10.
- Compensation to foreign missionaries is not precluded from being contributed to a Roth account even though the compensation would not have been includible in income if it were paid directly.
- The requirement that a Roth contribution not be excludible from income is only satisfied by a self-employed individual if the self-employed individual does not claim a deduction for the contribution.
The 2007 Final Regulations are generally effective for taxable years beginning on or after January 1, 2007. Provisions directly relating to Code section 402A are effective at the same time as the statute (January 1, 2006), including the rules prohibiting the transfer of value between a Roth account and other plan accounts, the rules regarding rollovers to Roth accounts and Roth IRAs, and the rules regarding treatment of excess deferrals. However, the rule requiring distribution of gap period income on excess deferrals is effective for taxable years beginning on or after January 1, 2007 (which, for calendar year plans, are generally distributed on or after January 1, 2008).
The extensive guidance published concerning Roth 401(k) (and 403(b)) contributions shows that the rules are many and the administration is, perhaps, cumbersome. However, a Roth program in a 401(k) or 403(b) plan can provide a significant boost to employees’ retirement savings and we encourage all businesses to consider the value of adopting a Roth feature. Please let us know if we can assist you with establishing a Roth program in your plan.