The IRS has proposed regulations regarding the taxation of distributions from Roth 401(k) accounts. The proposed regulations also address Roth 401(k) reporting requirements and designated Roth contributions in 403(b) plans. [71 FR 4320, REG-146459-05] Final regulations covering the basic rules for Roth 401(k) accounts were issued earlier this year. (See BeneBlog 1/9/06.)
Designation of 401(k) deferrals as Roth 401(k) contributions is permissible beginning 1/1/2006. Under current law, authorization of Roth 401(k) accounts would sunset December 31, 2010. Neither the earlier published regulations nor the newly proposed regulations address the potential sunset.
Qualified Distributions. Taxation of distributions from a Roth 401(k) account depend upon whether or not the distribution is a qualified distribution. As prescribed by IRC 402A(d)(2), a qualified distribution must be made on or after attainment of age 59-1/2, death, or disability, and must be made at least 5 years after establishment of the Roth 401(k) account.
The 5-year period begins on the first day of the employee’s taxable year during which the employee designated the first Roth 401(k) contribution under the plan. If the makes a direct rollover from a Roth 401(k) account under a different plan, then the 5-year period begins on the first day of the employee’s taxable year during which the employee had designated the first Roth 401(k) contribution under the transferor plan, if earlier.
Nonqualified Distributions. Roth 401(k) distributions that do not satisfy the conditions for qualified distributions are not eligible for the tax exemption that would apply to qualified distributions. Accordingly, income attributable to the designated Roth 401(k) contributions is taxable, although the contributions themselves – which had been included in taxable income upon contribution – are tax-free basis upon distribution.
The IRS declined requests to apply the Roth IRA special ordering rules for taxation of nonqualified Roth 401(k) distributions. Thus, a nonqualified distribution from a Roth 401(k) account is taxed under the rules of IRC 402 and IRC 72, treating the Roth 401(k) account separately from any non-Roth 401(k) distributions as prescribed by IRC 402A(d)(4). Note that the preamble of the final regulations published earlier this year stated that a 401(k) plan could grant a plan participant the right to allocate the amount of a 401(k) distribution that would come from a Roth 401(k) account versus the non-Roth 401(k) account.
Roth 401(k) Rollovers. The portion of any Roth 401(k) distribution that is not includible in income may be rolled over to a designated Roth account under a 401(a) plan only if – (1) The transaction is made by a direct rollover, rather than through direct distribution to the employee; and (2) The transferee plan accepts rollovers and agrees to separately account for the amount not includible in income. The transferor plan must report to the transferor plan the investment under the account and the first year of the 5-year period.
An individual may roll over the portion of a Roth distribution that is taxable to a 401(a) or 403(b) plan within 60 days of receipt. In the instance of rollover of taxable Roth 401(k) amounts, Roth participation under the transferor plan is not carried over to the transferee plan for purposes of the 5-year rule.
If a Roth 401(k) distribution has been made directly to the individual, then a rollover to another plan may not be made, but the individual may roll over any portion of the distribution into a Roth IRA within 60 days. Participation under the Roth 401(k) account does not count for purposes of the Roth IRA version of the 5-year rule.
The Roth IRA income limits on contributions do not apply for purposes of a rollover from a Roth 401(k) account to a Roth IRA. If only a portion of the distribution is rolled over, then the portion not rolled over is treated as consisting first of the amount of the distribution that is taxable.
Treatment of Excess Deferrals. If secess deferrals are not distributed by April 15 of the following year, then any portion of that distribution that is attributable to a designated Roth contribution is included in taxable income, with no exclusion for amounts attributable to basis. The result is dobule taxation: although the contribution was included in taxable income during the year contributed, it would also be included in taxable income during the year of distribution. In most instances, the way to avoid this double hit would be to either distribute excess deferrals before the April 15 deadline, or for the plan to provide highly compensated employees with the right to designate that distribution of excess deferrals should be made entirely from the non-Roth 401(k) account. Note, however, that if excess deferrals have remained undistributed and if the individual takes a distribution from the Roth 401(k) account, then a special ordering rule prevails, characterizing the first portion of that distribution to constitute distribution of excess deferrals, thereby circling back to the double taxation problem. Thus, if excess deferrals are present and if the April 15 deadline has passed, the individual should distribute the excess deferrals from the non-Roth portion of the account, if possible under the plan terms to do so, before taking a distribution from the Roth 401(k) account.
Designated Roth Accounts under 403(b) Plans. Generally 403(b) plans may permit members to designate contributions as Roth contributions under rules parallel to those that have been prescribed for 401(k) plans. The one additional nuance is the universal availability rule of 403(b)(12)(A)(ii): if any one member of a 403(b) plan is given the opportunity to designate a contribution to the plan as a Roth contribution, then all members of the plan must be given that same right. In contrast, for a 401(k) plan the right to designate a deferral as a Roth 401(k) contribution would be a plan feature subject to the nondiscriminatory availability rules of Reg.1.401(a)(4)-4.
Reporting and Recordkeeping. The administrator of a plan with Roth 401(k) accounts is generally responsible for keeping track of the 5-year period and the amount of contribution designated by a plan participant as Roth 401(k) contributions.
Effective Date. Reliance on the proposed regulations is permitted for any periods after the 1/1/2006 effective date of the statute. The reporting and recordkeeping requirements will not be effective prior to the 2007 plan year; but plan administrators are cautioned that compliance will necessitate keeping track of each account from the outset.