Roth Final Regulations
On April 27, 2007, the IRS issued the final regulations on designated Roth 401(k) and 403(b) distributions and reporting. The final regulations overwhelmingly represent the retention of the proposed regulations. However, there are a number of changes due to the Pension Protection Act and some from suggestions from commentators that were incorporated. The final regulations are largely in Q&A format as were the proposed regulations. There were also some changes to the final Roth 401(k) regulations.
For more information on this subject, check out our eSeminar: Final Roth Distribution Regulations: What you need to know! by clicking here
Determination of the five-year period
The five-taxable-year period to be satisfied in order to have a qualified distribution begins on the first day of the employee's taxable year when the employee first contributed a designated Roth contribution to the plan. It ends when the fifth consecutive taxable year thereafter is completed.
Determining the five-year period if a direct rollover occurs from designated Roth to designated Roth account
If a direct rollover is received from a designated Roth account under another plan, the five-taxable-year period for the recipient plan begins on the first day of the employee's taxable year for which the employee first had designated Roth contributions made to the other plan.
For example, a designated Roth contribution was made to Plan A in 2006 and was directly rolled to plan B in 2009. The first Roth contributions to plan B were made in 2009. In this example, the five-year tracking for plan B would start as of 2006 rather than 2009.
Five-year tracking for reemployed veteran under 414(u)
Designated Roth contributions made by a reemployed veteran are treated as made in the taxable year with respect to which the contributions relate. Reemployed veterans may identify the year for which a contribution is made for other purposes, such as for entitlement to a match, and the treatment for the five-year period of participation rule follows that identification. Absent such an identification, for purposes of determining the first year of the five-taxable-year period, the contribution is treated as made in the veteran's first taxable year in which a veteran's qualified military service begins, or if later, the first taxable year in which designated Roth contributions could be made under the plan.
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Taxation of nonqualified distributions
The Roth 401(k) will not have the special ordering rules that apply to Roth IRA Distributions
Special ordering rules available for Roth IRAs, which permit distributions to be sourced first from after-tax contributions, and thus not taxable, will not be extended to Roth 401(k) accounts. This is because section 402A does not contain the special ordering rules of section 408A(d). Thus, nonqualified distributions of designated Roth accounts will be made pro-rata from earnings and Roth contribution amounts.
Hardship amounts may be calculated based on the aggregate of Roth and pre-tax deferrals; but the distribution may be limited to pre-tax deferrals
The limit on elective contributions available for hardship distribution is an aggregate limit that includes both pre-tax deferrals and designated Roth contributions. An employee may limit the hardship distribution to the pre-tax account, even though part of the amount available for hardship is attributable to designated Roth contributions. Thus, the amount of elective deferrals available for distribution from a designated Roth account because of hardship generally would be a different amount than the total designated Roth contributions, even if the ordering rule in section 408A(d)(4) applied to distributions from designated Roth accounts.
Rollover of designated Roth contributions
The after-tax amount of the Roth contribution may only be moved by a direct rollover and never by a participant rollover. In addition, the rollover must be separately accounted for by the receiving plan.
A designated Roth amount that is directly rolled-over to another designated Roth account is subject to the separate account requirements of the new plan. However, the receiving plan does not have to have a separate designated account for the rollover Roth. The rollover designated Roth funds may be added to an existing separate designated Roth account. A qualified distribution that is rolled over is all basis.
Participant Rollover to Roth IRA
A distribution paid to a participant may be rolled over within 60 days to a Roth IRA. However, if only a portion is rolled over, the pre-tax (i.e. the earnings) is required to be rolled over first. The income limits applicable to Roth IRA contributions do not apply to a rollover from a Roth 401(k) or 403(b) to a Roth IRA.
Participant Rollover to designated Roth account
Only the taxable portion (i.e. the earnings) of the distribution may be rolled to a designated Roth within 60 days. However, the five-year tracking period is not carried over from the distributing plan. The recipient plan must provide for separate accounting of the designated Roth.
Determination of the five-year period after rollover to a Roth IRA
The period that the funds were in the designated Roth account does not count towards the five-taxable year period for the Roth IRA. However, if the Roth IRA was established before the rollover of the designated Roth account, the designated Roth rollover funds are placed on the five-taxable year period of the Roth IRA.
If a qualified distribution from a designated Roth account is rolled into a Roth IRA, the entire amount is treated as basis. Thus, a subsequent distribution of the exact amount of that rollover would be considered basis, regardless of whether the Roth IRA had completed the five-year period. However, whether the portion of the distribution from the Roth IRA attributable to earnings on the designated Roth rollover is also tax-free would depend on the Roth IRA having satisfied the five-year period.
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Employer stock distributions and Net Unrealized Appreciation (NUA)
To the extent that a qualified distribution includes employer securities, the distribution is not includable in gross income and the basis of each security is its fair market value as of the date of the distribution. To the extent there is appreciation in value of the security after the distribution, there is entitlement to capital gains treatment upon the security's subsequent sale.
If the distribution of employer securities is not a qualified distribution, the employer securities in the designated Roth account will be treated as a separate account. At the time of the ultimate disposition, the basis of the securities will be increased to reflect the portion of the distribution that exceeded the basis of the securities on the date of the distribution, so that such amount will not be taxed as appreciation upon the subsequent sale of the security.
Distribution to alternate payee or beneficiary
The age, death, or disability of the participant is to be used to determine whether the distribution is qualified even in the case of distribution to an alternate payee or beneficiary. However, an exception exists if the alternate payee or surviving spouse rolls the participant's Roth funds to a designated Roth account under a plan of his or her own employer.
Annuity contract distributions
Distribution of an annuity contract from a designated Roth account is not a distributable event for 402/402A purposes. Distributions from an annuity contract are treated as distributions. Determination of whether the distribution is qualified or not is made at the time of the distribution from the contract.
It may be impossible for the separate account requirements to be maintained within a single annuity contract because there is an allocation of charges for guarantees under the contract that apply to the total of all the accounts under the contract. Combined guarantees that apply to both accounts potentially transfer the value between the accounts, and that is prohibited under the separate account rules.The IRS and the Treasury Department have left open the possibility that additional guidance may be forthcoming.
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Reporting and Recordkeeping
The plan administrator is responsible for tracking the five-year period and for providing the plan administrator of the recipient plan with a statement indicating either: |
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The first year of the five-taxable year period and the portion of the distribution attributable to basis, or |
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That the distribution is a qualified distribution
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If distributed to the employee, rather than directly rolled over, the administrator must provide, upon request - the same information as above, except for the first year of the five-taxable year period.
The statement must be provided within 30 days following a direct rollover or participant request. (This information may be satisfied by including it on a statement attached to the check issued to the employee.)
Reporting a participant rollover to a recipient plan
In addition, a new report must be provided by the recipient plan administrator to the IRS regarding the acceptance of the rollover contribution.
The IRS will be issuing separate instructions that will provide a mailing address for this report. The information required on the report will include the following: |
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The employee's name and social security number |
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The year in which the rollover was made, and |
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Any other information required to determine the validity of the rollover
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However, until relevant forms and instructions are issued, no reporting is required.
Note: An employee rolling over a designated Roth to a Roth IRA would track it on a Form 8606.
Excess Roth deferrals will be treated in a similar fashion as excess pretax deferrals.
If Roth excess deferrals are returned by April 15 of the year after deferred, no adverse tax consequences will occur.
If they are returned after April 15 of the year after deferred, they will be included in gross income for the year deferred and the year of distribution and will not be eligible for rollover.
GAP Period Income
Gap period income is to be calculated on the return of excess deferrals. This remains true even after the repeal of the gap period income calculation on failed ADP and ACP tests in 2008 by PPA.
Rollovers between Roth 401(k)s and Roth 403(b)s
The final regulations permit a rollover of a designated Roth 401(k) to a designated Roth 403(b). The IRS attributed this change to the passage of PPA.
Modifications to the Final Roth 401(k) regulations
The final Roth 401(k) regulations were updated in the following ways: |
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The final regulations confirm that the involuntary cash-out and automatic rollover rules will be applied separately to designated Roth contributions. Thus, Roth and non-Roth amounts must be disaggregated for purposes of applying these rules. |
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Another interesting addition is that compensation for foreign missionaries is not precluded from being contributed to a designated Roth account merely because the compensation would not have been includible in gross income if paid directly. |
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Self-employed individuals may not exclude from gross income a designated Roth contribution, and may not claim a deduction for it. |
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Catch-up contributions may be designated Roth contributions. |
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The final regulations reflect the removal of the sunset provision of EGTRRA by PPA.
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Effective Date
The final regulations are effective April 30, 2007. They are applicable to taxable years beginning on or after January 1, 2007, with an exception for the rules applicable to maintaining the designated Roth in a separate account, as those rules are applicable as of January 1, 2006.
For more information on this subject, check out our eSeminar: Final Roth Distribution Regulations: What you need to know! by clicking here |
