Final Roth 401(k) Regulations!
Rev. 01/10/06, E-mail Alert 2006-01

Final 401(k) Roth Regulations Issued

Background
The Roth 401(k) was created by Economic Growth and Tax Recovery Reconciliation Act of 2001 (EGTRRA), which added Section 402A to the Internal Revenue Code. The IRS is currently in the process of issuing the rules on the Roth 401(k) in three parts: first, final regulations on administrative issues, which were proposed in March 2005; second, proposed rules on distributions and taxation and; third, a “sample” amendment to incorporate the Roth 401(k) provisions into the plan document. On the afternoon of December 30, 2005, the IRS released the Roth 401(k) final regulation portion. The effective date of the final regulations is January 3, 2006, and they will apply for plans permitting Roth 401(k) deferrals beginning on or after January 1, 2006. This article will describe the Roth 401(k) regulations. However, because the final regulations left some distribution and taxation rules to a subsequent release, some questions remain unanswered as to how Roth distributions will ultimately be taxed.

Plan Amendments
The final regulations state that the deadline for adopting the plan amendment to add Roth 401(k) provisions is the last day of the plan year in which Roth 401(k) contributions are started. So calendar year 401(k) plans that begin Roth contributions in 2006 must be amended by December 31, 2006.

Off-calendar-year plans are to be amended by the end of the plan year in which Roth 401(k) contributions begin. For example, an off-calendar-year plan with a March 31 year-end that starts Roth contributions on January 3, 2006, must be amended by March 31, 2006.

Roth 401(k) versus Roth IRA
There are several significant differences between Roth 401(k) contributions and Roth IRA contributions.

1. Unlike Roth IRAs, which have an income limit, plan participants may make Roth 401(k) contributions without regard to the amount of their adjusted gross income (AGI).
   
2. Plan participants may not convert existing pretax elective deferrals to Roth 401(k) contributions. Traditional IRA pre-tax contributions may be converted to Roth IRA contributions.
   
3. Distribution ordering rules, which apply to Roth IRAs, do not seem to apply to Roth 401(k)s. (More details are expected on this subject when the tax recovery rules are proposed and then finalized.)
   
4. Roth 401(k) contributions are subject to required minimum distribution rules. Roth IRA contributions are not.

Designated Roth Contributions. The new contributions must meet several requirements. Specifically, Roth contributions are defined in the regulations as elective contributions under a 401(k) plan that are:

1. Irrevocably designated by the participant as Roth contributions (made in lieu of all or a portion of the participant’s pretax elective deferrals).
   
2. Subject to applicable income-tax withholding requirements and included in the participant’s gross income.
   
3. Maintained in the plan in a separate account. Note: this does not have to be literally a separate account requiring the separation of the trust investments, but the amounts attributed to the designated Roth account must be record kept separately at all times.

Some Elective Deferral Rules Apply. Roth contributions must satisfy the same rules that apply to traditional pretax elective deferrals. Specifically, Roth contributions are nonforfeitable , subject to the actual deferral percentage (ADP) test, may be treated as catch-up contributions, are available for participant loans (if plan loans are permitted), are subject to withdrawal restrictions, and are subject to required minimum distribution (RMD) rules. An employee must have the effective opportunity to make (or change) an election to make designated Roth contributions at least once during each plan year.

Comment: ERISA 404(c) rules permitting participant’s, rather than employer's, to be responsible for their own investment returns apply to Roth contributions. Thus, a plan choosing to comply with 404(c) must permit investment elections at least quarterly.

Roth contributions must be accounted for separately. The Roth separate account requirements are as follows:

1. Designated Roth contributions must be credited and debited to a designated Roth account.
   
2. Gains and losses and other credits or charges to the designated Roth account must be separately allocated on a reasonable and consistent basis.
   
3. Each participant's total after-tax account is to be accurately kept, reflecting Roth contributions and subtracting Roth distributions.
   
4. Separate accounting is required from the time a designated Roth contribution is first made to the plan until the Roth account is completely distributed.
   
5. The only permitted rollover contributions to the designated Roth 401(k) account are those from a Roth 401(k) designated account.
   
6. Matching contributions may be made on the Roth deferrals, but the match may not be allocated to the Roth account. Likewise, forfeitures may not be allocated to a Roth account.

Stand-alone Roth Plans Not Permitted
The final regulations confirm that Roth 401(k) provisions are only permitted as part of a 401(k) plan that provides for pretax elective contributions. Thus, a plan may not be designed to offer only the Roth 401(k) contribution option.

Automatic Enrollment
The plan document must specify the extent to which default deferral contributions are to be treated as pretax elective or designated Roth contributions. If an employer designates the automatic enrollment deferral as a Roth contribution, in the absence of an employee election replacing the default, participant contributions are irrevocably Roth contributions.

Direct Rollovers from Roth 401(k) Accounts
A direct rollover from a Roth account may be made only to another designated Roth 401(k) account or to a Roth IRA. For direct rollover purposes, the designated Roth account is treated as separate from the rest of the 401(k) plan. Thus, if the participant’s Roth account is less than $200, the plan is not required to offer a direct rollover of the Roth account or to apply the automatic rollover provisions in the event of an involuntary cash-out. This could clearly complicate administration, where the regular pre-tax amounts are subject to the automatic rollover provisions.

ADP/ACP Correction Methods
If a highly compensated employee (HCE) has made both Roth and pretax contributions in the same plan year and the plan fails ADP testing, the regulations permit the HCE to elect whether refunds of excess contributions are treated as pretax, Roth, or a combination of the two. Alternatively, the employer or document provider may design the plan by choosing one of the correction methods instead of allowing the participant to choose. Although the distribution of excess Roth contributions is not taxable, the income allocable to a corrective distribution of the Roth excess contribution is taxable. Similar rules exist for the ACP test. The plan document must reflect the extent to which a plan permits employees to determine the “character” of excess and excess aggregate contributions. Once the IRS “sample” amendment and tax recovery rules are issued, it will be clearer how to best address this issue.

EGTRRA Sunset
If the EGTRRA sunset provision for the Roth 401(k) is not repealed before December 31, 2010 and the Roth 401(k) is eliminated from the Tax Code, the IRS will need to issue guidance to clarify the situation at that time. The Pension Protection Act of 2006 made EGTRRA permanent, so there will be no sunset in 2011.

Bill Grossman, QPA