Guest Article

(From the May 07, 2007 issue of Deloitte's Washington Bulletin, a periodic update of legal and regulatory developments relating to Employee Benefits.)

IRS Issues Final Regulations on Distributions from Roth 401(k)s

The Internal Revenue Service has issued final regulations on the tax treatment of distributions from Roth 401(k) accounts. 72 FR 21103 (April 30, 2007). The final regulations fill the gap left by the more comprehensive final Roth 401(k) regulations IRS published early in 2006. The final regulations are effective April 30, 2007, but generally apply to taxable years beginning on or after January 1, 2007.

Background

The Economic Growth and Tax Relief Reconciliation Act ("EGTRRA") of 2001 (P.L. 107-16) 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. 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 ($15,500 in 2007) instead of the IRC § 219(b) limit on contributions to Roth IRAs ($4,000 in 2007). 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 previously 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, those final regulations did not provide guidance on the tax treatment of distributions of designated Roth contributions or the reporting requirements relating to designated Roth contributions. These new regulations are designed 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. The final regulations clarify that if the distribution is made to an alternate payee or beneficiary, the participant's age, disability status, or death are used to determine whether the distribution is qualified.

Whether a payment is a qualified distribution depends on the actual year the payment is made from the Roth 401(k) account. Thus, a payment can be a qualified distribution even if it is attributable to a prior calendar year (such as a required minimum distribution for a previous year) or is part of a series of distributions that started before the employee attained age 59½, became disabled, or died.

The five-year period of participation begins on the first day of the employee's taxable year for which the employee first makes designated Roth contributions to the plan, and ends at the completion of five consecutive taxable years. However, excess deferrals, excess contributions distributed to prevent an average deferral percentage (ADP) testing failure, and contributions returned to the employee pursuant to IRC § 414(w) [relating to automatic enrollment 401(k) plans] do not begin the five-year period of participation.

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 begins 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 regulations take a different approach in the case of a rollover from a Roth 401(k) to a Roth IRA. A similar five-year requirement applies to distributions from Roth IRAs, except the period begins with the first taxable year for which the individual makes a contribution to any Roth IRA. But in the case of a rollover from a Roth 401(k) to a Roth IRA, the final regulations provide the period the rolled-over funds were in the Roth 401(k) does not count towards the five-year requirement for the Roth IRA. However, 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 regulations 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 is not available with respect to these amounts. To insure proper accounting, the transferring plan is 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 can 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 do 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.

An employee who receives an eligible rollover distribution directly from his or her Roth 401(k) also can use the 60-day rollover option to transfer the taxable portion to another Roth 401(k) or Roth 403(b) plan. The regulations require the receiving plan to notify the IRS it has accepted the rollover contribution. However, this reporting is required only to the extent provided in Forms and Instructions; thus, until Forms and Instructions are issued, no reporting is required.

The regulations do 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 regulations provide any distribution attributable to an excess deferral that is a designated Roth contribution is includible in income and not eligible for rollover. Furthermore, if there are excess deferrals that are designated Roth contributions that are not corrected by the April 15 deadline, the final regulations provide the first amounts distributed from the designated Roth account will be treated as distributions of excess deferrals and earnings until the full amount of those excess deferrals (and attributable earnings) are distributed.

Reporting and Recordkeeping

In general, according to the final regulations, the same reporting requirements 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. Employees do not have any reporting obligations with respect to designated Roth contributions.

The regulations require plan administrators to track each employee's designated Roth contributions as well as the five-year taxable period for each employee. In the case of direct rollovers, the plan administrator of the transferring plan is 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. The plan administrator for the receiving plan can rely on these statements. For distributions made directly to employees, the plan administrator must provide this same information to the employees upon request, except the statement does not have to indicate the first year of the five-year taxable period. This information must be provided to the receiving plan (or employee, if applicable) within a reasonable period of time, but not later than 30 days after the direct rollover (or employee request). The plan administrator can provide the information on a statement attached to the employee's check.

The Future of Roth 401(k)s

The initial Roth 401(k) regulations issued in 2006 were met with little enthusiasm because of questions about the long-term viability of Roth 401(k) arrangements. Like the rest of the EGTRRA changes, new IRC § 402A had been scheduled to sunset after December 31, 2010. As a result, even those individuals who started making designated Roth contributions in 2006 -- as soon as the option became available -- faced an uncertain legal environment when their five-year participation requirement ended.

Fortunately, the Pension Protection Act ("PPA") of 2006 (P.L. 109-280) took care of that problem by making EGTRRA's pension provisions -- including the Roth 401(k) provision -- permanent. As a result, employers now appear more inclined to at least consider a Roth 401(k) option. According to the Profit Sharing Council of America's ("PSCA") Roth 401(k) Survey 2007, 69 percent of companies that do not currently offer a Roth 401(k) plan are more likely to do so due to EGTRRA permanency. And the latest round of regulatory guidance should help, too. Approximately one-fourth of participants in the PSCA Survey, which was done before the IRS issued these final regulations, cited "insufficient regulatory clarification" as a reason for not implementing a Roth 401(k).

But there are still other reasons employers may choose not to offer a Roth 401(k). According to the PSCA Survey, the top reasons for not implementing a Roth 401(k) include concerns about participant education (59.5 percent), lack of participant demand (56.8 percent), and the additional administrative burden (54.7 percent). Neither EGTRRA permanence nor the IRS's regulations address these issues.

The information in this Washington Bulletin is general in nature only and not intended to provide advice or guidance for specific situations. If you have any 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, Erinn Madden 202.572.7677, Bart Massey 202.220.2104, Laura Morrison 202.879.5653, Martha Priddy Patterson 202.879.5634, Tom Pevarnik 202.879.5314, Tom Veal 312.946.2595, Deborah Walker 202.879.4955. Copyright 2007, Deloitte.