Flexibility w/early in-service Roth w/drawals

Participant is under age 59 1/2 and has less than 5 years in the Plan.

Participant took a hardship withdrawal and Plan Sponsor created 1099-R's splitting the h/s between both 401(k) and Roth.

Plan Sponsor did not realize earnings on the Roth portion are taxable and they didn't calculate a taxable amount on the earnings of the Roth that were allocated to the H/S.

They are asking now, after the fact, if the Roth portion of the H/S can be treated fully as basis. I looked in the Plan Doc but couldn't find that it specifies. It only says that a Plan Admin can choose how to order the money types.  They chose to go prorata, and yes they are informing the TPA just now about this from last year.

If there is a payment from an account in which the participant has basis, there is no election available that to consider the first dollars distributed to be all basis.

It is worth noting that some plans use the ability to specify order of accounts from which payments are made to preserve basis in the plan, particularly for amounts paid from Roth accounts. 

Note that plans that allow participants to designate the order of accounts from which payments are made often find that participants have an expectation that they can request a payment that has the least associated taxes.  This can be a nightmare, and also possibly crosses the line of the plan offering tax advice.

Under certain circumstances (for example, after there has been a deemed distribution from a pre-tax account and subsequently loan repayments resumed) where there could be basis in that pre-tax account.

Paul I, thank you for this insight. In your experience:

How many plans’ sponsor/administrators understand the details of what a plan may provide or allow, and make a considered choice about what ordering a distributee may elect (or is precluded from choosing)?

And how many fall in with the service provider’s norms and system choices, unaware of how those specs might affect a distributee’s income tax treatments?

Most of the pre-approved plans I have seen during the Cycle 3 restatements moved away from giving participants full discretion to designate the order of withdrawal from the available sources.  There does remain a fair amount of flexibility with many offering a plan sponsor choice between pre-tax and Roth accounts as: pro-rata, pre-tax before Roth, or Roth before pre-tax.

There also is the variability in the sources the plan sponsor wishes to make available for withdrawals.  A common order of withdrawal is first to take rollover and voluntary after-tax, then elective deferrals to the extent they participant is eligible to do so, followed by employer sources (match or NEC).  The thought process is first in line are accounts that are the employee's money so they should have access at will, then it is the employee's money but may be restricted because this after all is a retirement plan, and lastly it's the company's contribution for retirement and not a bonus plan.

Most plans have been around for many years and often do not change this type of plan provision as the years and restatement cycles roll along.  For new plans, the service provider is likely to push and get approval for their preferred approach.

As a side note, now that Secure Act 2.0 allows the employee to designate employer contributions as Roth, there are at least two new potential buckets to consider. As a further side note, if the employee has a seasoned Roth account are new Roth employer contributions seasoned by association or require independent seasoning?