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Guest Article

Deloitte

(From the January 30, 2006 issue of Deloitte's Washington Bulletin, a periodic update of legal and regulatory developments relating to Employee Benefits.)

IRS Issues Proposed Regulations Regarding Distributions from Roth 401(k)s


The Internal Revenue Service on January 26, 2006, issued proposed regulations on the tax treatment of distributions from Roth 401(k) accounts. 71 FR 4320 (January 26, 2006). The proposed regulations are designed to supplement the final Roth 401(k) regulations IRS published on January 3. According to the preamble, taxpayers can rely on these proposed regulations until final rules are issued.

Although the proposed regulations deal with most questions relating to distributions from Roth 401(k) accounts, including questions about plan administrators' reporting requirements with respect to such distributions, they do not address the potential effect of the EGTRRA sunset provision on distributions occurring in 2011 and beyond. ("EGTRRA" refers to the Economic Growth and Tax Relief Reconciliation Act of 2001 (P.L. 107-16).) All EGTRRA provisions -- including the Roth 401(k) provisions -- are scheduled to expire on December 31, 2010. The preamble to the proposed regulations acknowledges that, "Unless the EGTRRA sunset provision is repealed before it becomes effective, additional guidance will be needed to clarify its application."

Background

The EGTRRA amended the Internal Revenue Code (IRC) to add section 402A, which permits 401(k) and 403(b) plans to establish "qualified Roth contribution programs" beginning in 2006. (As noted, like other EGTRRA provisions IRC § 402A is scheduled to sunset on December 31, 2010.) These programs allow participants to designate part or all of their elective deferrals as Roth contributions ("designated Roth contributions").

Basically, the same tax rules that apply to Roth IRAs apply to Roth 401(k) and Roth 403(b) plans. Designated Roth contributions are subject to income and employment taxes at the point of contribution, but subsequent distributions of these contributions -- and, most important, any related earnings -- will not be taxed if certain requirements are satisfied. However, designated Roth contributions are subject to the IRC § 402(g) limit on elective deferrals ($15,000 in 2006) instead of the IRC § 219(b) limit on contributions to Roth IRAs ($4,000 in 2006). Unlike Roth IRAs all participants in plans with Roth 401(k) features, regardless of income, are eligible to make designated Roth contributions.

Plans are not required to offer qualified Roth contribution programs. Those that do offer these programs must amend their plans accordingly. For example, these plans must specify the extent to which participants can designate elective deferrals as Roth contributions and provide for keeping designated Roth contributions -- including earnings attributable to such contributions -- in separate accounts.

The IRS already has issued final regulations that address a number of issues relating to operating Roth 401(k) plans, including designating elective deferrals as designated Roth contributions, separately accounting for designated Roth contributions, and applying rules for elective deferrals (e.g., restrictions on distributions, minimum required distribution rules, and actual deferral percentage testing) to designated Roth contributions. However, the final regulations do not provide guidance on the tax treatment of distributions of designated Roth contributions or the reporting requirements relating to designated Roth contributions. These newly proposed regulations are intended to fill that void.

Qualified Distributions

Only "qualified distributions" from Roth 401(k) accounts are eligible for tax preferred treatment. A qualified distribution is one that occurs after a five-year period of participation and that either (1) is made on or after the date the employee attains age 59½, (2) is made after the employee's death, or (3) is attributable to the employee being disabled.

Under the proposed regulations, this five-year period of participation would begin on the first day of the employee's taxable year for which the employee first made designated Roth contributions to the plan and end at the completion of five consecutive taxable years. The five-year period of participation is plan specific, so an individual making designated Roth contributions to more than one Roth 401(k) plan must satisfy the five-year period with respect to each of those plans. However, in the case of a direct rollover from one Roth 401(k) plan to another, the five-year period of participation for the receiving plan would begin on the first day of the employee's taxable year for which he or she made designated Roth contributions to the transferring or receiving plan, whichever is earlier.

The proposed regulations would take a different approach in the case of a rollover from a Roth 401(k) to a Roth IRA. A similar five-year rule applies to distributions from Roth IRAs, but the period begins with the first taxable year for which the individual makes a contribution to any Roth IRA. However, in this situation rather than give individuals credit for the time since they first made contributions to the Roth 401(k), the proposed regulations would provide this time does not count for purposes of applying the five-year rule to the Roth IRA. Of course, if the individual had established and started contributing to the Roth IRA at least five years before the rollover, then the five-year rule would be satisfied with respect to all assets in the Roth IRA -- including those attributable to the rollover.

Rollovers

In the case of rollovers from one Roth 401(k) to another, the proposed regulations would require a direct rollover of any portion that would not be includible in the employee's income if distributed directly to the employee. Thus, the 60-day rollover option would not be available with respect to these amounts. Additionally, these amounts could be rolled over only to another 401(k) plan, and not to a 403(b) plan. To insure these amounts are properly accounted for by the receiving plan, the transferring plan would be required to report the amount of the investment in the contract and the first year of the five-year period to the receiving plan.

If a Roth 401(k) makes an eligible rollover distribution directly to the employee, he or she could use the 60-day rollover option to transfer all or part of the distribution amount to a Roth IRA. Significantly, the adjusted gross income limits for contributing to Roth IRAs would not apply for this purpose. As a result, even employees who could not otherwise contribute to a Roth IRA can set one up to accept rollovers from their Roth 401(k) accounts. This could become important if Congress fails to repeal the EGTRRA sunset provision.

An employee who receives an eligible rollover distribution directly from his or her Roth 401(k) also could use the 60-day rollover option to transfer the taxable portion to a Roth 401(k) or Roth 403(b) plan. In this case the proposed regulations would require the receiving plan to notify the IRS it has accepted the rollover contribution.

The proposed regulations would not permit rollovers from Roth IRAs to Roth 401(k)s.

Excess Elective Deferrals

Designated Roth contributions are treated as elective deferrals for numerous purposes, including the IRC § 402(g) limit on elective deferrals. If an employee's total elective deferrals exceed the IRC § 402(g) limit for a year, the excess can be distributed by April 15th of the following year without adverse tax consequences to the employee. But if the excess deferrals are not distributed by the April 15 deadline, the proposed regulations would provide any distribution attributable to an excess deferral that is a designated Roth contribution is includible in income and not eligible for rollover. The gap period income rules also would apply to these excess deferrals.

Reporting and Recordkeeping

In general, according to the proposed regulations, the same reporting requirements would apply to Roth 401(k)s as apply to other plans. A contribution to and distribution from a Roth 401(k) must be reported on Form W-2 and Form 1099-R, "Distributions from Pensions, Annuities, Retirement or Profit-Sharing Plans, IRA, Insurance Contracts," respectively. The preamble indicates the IRS expects to change the instructions to Form 1099-R to require that a separate Form 1099-R be used to report the amount of a distribution from a Roth 401(k), the taxable amount with respect to the distribution, and the first year of the five-year taxable period.

The proposed regulations would require plan administrators to track the five-year taxable period for each employee and each employee's designated Roth contributions. In the case of direct rollovers, the plan administrator of the transferring plan would be required to provide the receiving plan with a statement indicating either the first year of the five-year taxable period and the portion of the distribution attributable to basis, or that the distribution is a qualified distribution. For distributions made directly to employees, the plan administrator would have to provide employees this same information upon request, except the statement would not have to indicate the first year of the five-year taxable period. This information would have to be provided to the receiving plan (or employee, if applicable) not later than 30 days after the direct rollover (or employee request).


DeloitteThe information in this Washington Bulletin is general in nature only and not intended to provide advice or guidance for specific situations.

If you have questions or need additional information about articles appearing in this or previous versions of Washington Bulletin, please contact: Robert Davis 202.879.3094, Elizabeth Drigotas 202.879.4985, Taina Edlund 202.879.4956, Laura Edwards 202.879.4981, Mike Haberman 202.879.4963, Stephen LaGarde 202.879-5608, Bart Massey 202.220.2104, Diane McGowan 202.220.2077, Martha Priddy Patterson 202.879.5634, Tom Pevarnik 202.879.5314, Carlisle Toppin 202.220.2067, Tom Veal 312.946.2595, Deborah Walker 202.879.4955.

Copyright 2006, Deloitte.


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