The U.S. Internal Revenue Service (IRS) recently issued two new pieces of guidance regarding Roth 401(k) contributions under 401(k) plans. First, the IRS issued proposed regulations on the treatment of rollovers of Roth 401(k) distributions and on the taxation and reporting of distributions from Roth 401(k) accounts. The proposed regulations address many of the unanswered questions regarding distributions from Roth 401(k) accounts, including how to measure the five-year participation requirement for qualified distributions and how non-qualified distributions will be taxed. Second, the IRS issued a sample plan amendment regarding Roth 401(k) contributions (to be adopted by the end of the plan year in which the contributions are first available).
The proposed regulations and sample plan amendment provide welcome guidance for plan sponsors. However, some questions remain unanswered, and there are significant administrative obligations associated with offering Roth 401(k) contributions. Plan sponsors should review the new guidance carefully and confirm that the plan’s trustee and third-party administrator are prepared to handle the record-keeping and reporting functions required by the new guidance.
Distributions from Roth 401(k) Accounts
The IRS anticipates that the proposed regulations governing distributions from Roth 401(k) accounts, when finalized, will become effective for tax years beginning on and after January 1, 2007. However, as noted below, certain provisions in the proposed regulations are proposed to become effective for tax years beginning on and after January 1, 2006. Plan sponsors may rely on the proposed regulations immediately, and if future guidance is more restrictive, it will not be applied retroactively.
Qualified and Non-qualified Roth Distributions
As described in our article regarding the general rules for Roth 401(k) contributions (Roth 401(k) Roadmap for Employers), the tax treatment of distributions from Roth 401(k) accounts depends on whether the distribution is a “qualified” distribution. A qualified distribution, which is not subject to federal income tax, is a distribution made after a participant reaches age 59-1/2, dies or becomes disabled, and in all events after the participant has satisfied a five-year participation requirement. Non-qualified distributions are partially taxed, as described below.
Five-Year Participation Requirement
The five-year participation period begins on the first day of the calendar year in which the participant first made Roth 401(k) contributions and ends upon the completion of five consecutive calendar years. The five-year participation period is a one-time requirement, not a rolling requirement that applies separately to each year’s Roth 401(k) contributions. For example, if a participant first makes Roth 401(k) contributions on July 1, 2006, the participant’s five-year participation period would begin on January 1, 2006, and end on December 31, 2010. Distributions from the participant’s Roth 401(k) account any time after December 31, 2010, including distributions of Roth 401(k) contributions made during 2007 through 2010, would satisfy the five-year participation requirement.
Taxation of Non-qualified Roth Distributions
Under the proposed regulations, non-qualified distributions from Roth 401(k) accounts are subject to split taxation. In other words, the return of monies originally contributed as Roth 401(k) contributions are not taxed, but the earnings on such contributions are subject to federal income tax (and possibly a penalty tax if the distribution occurs before the participant attains age 59-1/2). In addition, distributions from Roth 401(k) accounts are subject to a pro rata basis recovery rule, which means each distribution must consist of both returned contributions (non-taxable) and a pro rata portion of the earnings on such contributions (taxable). For example, if a $5,000 non-qualified distribution is made from a Roth 401(k) account valued at $10,000 (consisting of $9,400 in Roth 401(k) contributions and $600 of earnings), the distribution will consist of $4,700 in a tax-free return of contributions and $300 in taxable earnings. This is the same rule that applies to distributions from regular after-tax contribution accounts (for post-1986 contributions). However, note that this rule differs from the rule that applies to non-qualified distributions from Roth IRAs. Participants in Roth IRAs are permitted to withdraw all of their non-taxable Roth IRA contributions first before withdrawing any of their taxable earnings.
In general, the proposed regulations provide that distributions from Roth 401(k) accounts may be rolled over to a Roth 401(k) account under another employer plan or to a Roth IRA. However, effective for tax years beginning on and after January 1, 2006, complicated rules govern Roth 401(k) rollovers (i.e., direct rollovers versus 60-day rollovers) and the carryover treatment of the five-year participation period in rollover situations.
If a participant wants to roll over his or her entire Roth 401(k) account to another employer plan, this can only be accomplished through a direct rollover to a plan qualified under Internal Revenue Code Section 401(a) that offers Roth 401(k) contributions and will account separately for the rollover. If the participant’s Roth 401(k) account is instead distributed to the participant, then only any taxable portion of the distribution (i.e., the earnings portion of a non-qualified distribution) can be rolled over within 60 days to a Roth 401(k) account under another employer’s plan. Thus, a 60-day rollover is not available for the non-taxable portion of a Roth 401(k) distribution. If a participant wants to roll over only a portion of a non-qualified Roth 401(k) distribution, the taxable portion of the distribution is rolled over before the non-taxable portion.
In the case of a direct rollover from one Roth 401(k) account to another employer’s Roth 401(k) account, the time counted toward the participant’s five-year participation period under the first employer’s plan carries over to the new employer’s plan. However, in the case of a 60-day rollover (of the taxable portion of a distribution), the participant’s five-year participation period under the first employer’s plan does not carry over to the new employer’s plan. The proposed regulations do not address whether a plan can accept Roth 401(k) rollovers if the plan does not provide for Roth 401(k) contributions. Several commentators have asked the IRS to clarify this point in the final regulations, and the IRS has suggested in informal question and answer sessions that only plans that actively offer Roth contributions may accept rollovers that include Roth contributions.
Rollovers from Roth 401(k) accounts to Roth IRAs can be accomplished through a direct rollover or a 60-day rollover. Regardless of the type of rollover, rules for the five-year participation periods and for taxation of distributions vary from those applied to Roth 401(k) rollovers to another employer plan. The proposed regulations also finally clarify that distributions from Roth IRAs may not be rolled over to Roth 401(k) accounts. The chart below summarizes the proposed regulations regarding rollovers from Roth 401(k) accounts:
Record-Keeping and Reporting
The proposed regulations clarify that the separate accounting requirement for Roth 401(k) contributions does not permit any transaction or accounting methodology that transfers value between Roth 401(k) accounts and other accounts under a plan. This rule is proposed to become effective for tax years beginning on and after January 1, 2006.
The proposed regulations provide that the administrator of a plan with Roth 401(k) contributions is responsible for tracking both the five-year participation period for each employee and the amount of the employee’s Roth 401(k) contributions. With respect to rollovers, a plan administrator that is directly rolling over a distribution from a Roth 401(k) account is required to provide the plan administrator of the receiving plan with a statement indicating either: (i) the first year of the five-year participation period and the part of the distribution attributable to Roth 401(k) contributions; or (ii) that the distribution is a qualified distribution. For a distribution that is not a direct rollover, similar information must be provided to the participant on request, except that the statement does not need to include the first year of the five-year participation period. This information must be provided within a reasonable period following the direct rollover or participant request but no later than 30 days after the direct rollover or participant request. For plans accepting Roth 401(k) rollovers, the recipient plan administrator is entitled to rely on the distributing plan’s statement. In the case of a 60-day rollover from a Roth 401(k) account, the recipient plan administrator must notify the IRS of the plan’s acceptance of the rollover and must provide detailed information regarding the transaction. (Several commentators have asked the IRS to eliminate this notice requirement in the final regulations because the IRS Form 1099-R issued by the distributing plan provides adequate information regarding the 60-day rollover, and, therefore, additional reporting by the recipient plan would be redundant and unduly burdensome.)
The record-keeping and reporting requirements for Roth 401(k) contributions are proposed to become effective for tax years beginning on and after January 1, 2007, but plan sponsors should contact their plan’s trustee and third-party administrator as soon as possible to ensure their plan will be ready to comply with the new requirements. In addition, if a plan accepts Roth 401(k) rollovers during 2006, the recipient plan administrator should request representations from the distributing plan that the distribution being rolled over is from a Roth 401(k) account and specifying the part of the distribution attributable to Roth 401(k) contributions.
The proposed regulations also amend the IRS’s 2004 proposed regulations under Internal Revenue Code Section 403(b) to provide that Roth contributions may be offered under 403(b) plans, subject to the same general rules that govern Roth 401(k) contributions. However, there is a unique rule regarding Roth contributions under 403(b) plans—namely, the proposed regulations provide that the “universal availability” requirement for elective deferrals under 403(b) plans includes the right to make Roth contributions. This means that if any participant has the right to make Roth contributions under a 403(b) plan, then all participants in the plan must be given that same right.
In addition, the proposed regulations generally prohibit rollovers of Roth contributions between 403(b) plans and 401(k) plans. Specifically, the non-taxable portion of a distribution from a Roth 403(b) account cannot be rolled over to a 401(k) plan, and the non-taxable portion of a distribution from a Roth 401(k) account cannot be rolled over to a 403(b) plan. Several commentators have asked the IRS to reconsider this rule because it is inconsistent with the rule permitting rollovers of pre-tax elective deferrals between 403(b) plans and 401(k) plans.
Plan sponsors are required to adopt a plan amendment providing for Roth 401(k) contributions by the end of the plan year in which the contributions are first available. To help plan sponsors comply with this requirement, the IRS has issued a sample plan amendment (Sample Amendment for Roth Elective Deferrals) regarding Roth 401(k) contributions. The sample amendment covers (i) the effective date and definition of Roth 401(k) contributions; (ii) the treatment of Roth 401(k) contributions as regular 401(k) contributions unless specifically provided otherwise; (iii) the separate accounting required for Roth 401(k) contributions and related earnings/gains under the plan; (iv) the rules on rollovers of Roth 401(k) contributions out of and into the plan; and (v) the rules on correction of excess contributions for participants who have both regular and Roth 401(k) contributions.
The sample amendment tracks the format used for prototype plans, which means it has two parts—general provisions for the “basic plan document” (in the form of an appendix) and optional provisions for the employer-specific “adoption agreement.” Sponsors of individually designed plans that do not use adoption agreements will need to work with their counsel to adapt the IRS’s sample amendment language for their plans.