Roth 401(k) Proposed Regulations
Rev. 02/24/06, E-mail Alert 2006-04

Proposed Roth 401(k) Distribution, Tracking and Reporting Regulations
With the release of Proposed Roth 401(k) Regulations on distributions, taxation and reporting practitioners are finding surprises, clarifications and complications caused by the interaction of a number of rules. The counting of five years for the exclusion (from taxes) period starts from as of January 1 of the year in which the first designated Roth contribution occurs. The subject becomes an exercise in fascination when contemplating the complications that can occur with real-life transactions such as the direct rollovers to Roth IRAs, the direct rollover to another employer plan; the merger of plans or a participant rollover within 60 days of receipt of Roth 401(k) funds to another plan. We will present the basics of the proposed Roth distribution rules in this article and in a future article we will discuss the various rollover issues including the five-year tracking when combined with another Roth account.

403(b) Roth Addressed. The proposed rules addressed the Roth 403(b) account and stipulated that the Final Roth 401(k) regulations apply to Roth 403(b) accounts. The proposed rules also stated that a Roth 401(k) could not be rolled into a Roth 403(b) account nor could a Roth 403(b) be rolled into a Roth 401(k).

A “qualified distribution” from a Roth 401(k) or Roth 403(b) of earnings and amounts contributed is not subject to federal income tax, i.e. is tax-free. A “qualified distribution” is one that is made after attainment of age 59½, or at death or disability, provided the five-year exclusion period has been met.

The five-year rule begins as of January 1 of the year that the first Roth 401(k) or 403(b) deferral contribution is made to the plan.

Example: If Mary contributes to her Roth 401(k) for the first time on October 31, 2006, Her five-year exclusion period begins on January 1, 2006 and runs for 5 consecutive years. Thus, once 2006, 2007, 2008, 2009 and 2010 are completed, Mary would have satisfied the five-year requirement portion of the “qualified distribution” rule. To complete the qualified distribution definition Mary would have to attain age 59½ or become disabled or die.

The five-year rule applies separately to each plan an individual participates in over his or her career.

Example: Joe works for ABC company from 2009 to 2018. Joe makes Roth 401(k) contributions from 2009 to 2018. Joe has satisfied the 5-year rule with the ABC company and once he attains age 59½ (or dies or becomes disabled), Joe will have met the definition of a qualified distribution for any funds withdrawn. However, in 2019, Joe who is now age 45 changes jobs and starts work at NBC company. Joe makes Roth 401(k) contributions to the NBC company plan starting in 2019. The 5-year rule starts anew for the Roth contributions made to the NBC company plan provided Joe does not rollover the ABC company contribution. (We examine the rollover rules in detail in this article.)

A nonqualified distribution is defined as any distribution that does not meet the definition of a qualified distribution. Thus, if the five-year rule is not met, even if the individual is over age 59½, then the distribution is not a qualified distribution and thus, is not tax free. If the five-year rule is met but the individual has not yet attained age 59½ or older or become disabled, then the distribution is also not a qualified distribution.

Tax treatment of nonqualified distributions is as follows. There is a pro rata distribution of earnings and Roth contributions. (The pro rata method is the same method used with after-tax contributions in a qualified plan after 1986 and also the same method used for after-tax amounts in a traditional IRA.) The earnings are subject to taxation and to a 10% penalty if the individual is under age 59½. If over 59½, the distributed earnings are only subject to taxation and not to the 10% penalty.

Example, if an IRA owner has $10,000 in nondeductible (after tax) money in his or her traditional IRA and a total balance in all of his or her traditional IRAs of $50,000 and a distribution of $5,000 was made. The non-taxable amount of the distribution would be calculated as follows. $10,000 divided by $50,000 times the $5,000. Thus, $1,000 of the $5,000 would be after-tax dollars and $4,000 would be pretax. For an article on nondeductible reporting for IRAs, click here.

Portability creates complexity. If we are dealing with only one plan and there is no movement of the Roth 401(k) funds to another plan or an IRA the definition of a “qualified distribution” would quite simply end here. However, portability is possible and indeed probable. Therefore, the proposed regulation presents very comprehensive, even complicated, rules to cover the method of handling the five-year tracking and the various situations that may arise when moving Roth funds. We will discuss the options and results in a future issue.

Introduction of Tracking Report. Within 30 days of the direct rollover, the plan sending the direct rollover of a designated Roth account must furnish the receiving plan information regarding the Roth 401(k) account. The information must include the first year of the five-year period and the amount of the Roth designated account. If the Roth amount is already eligible to be a qualified distribution, this must also be indicated. For a participant distribution, the same information is to be provided if the participant requests it. This requirement is effective as of January 1, 2007.

Loans. The proposed regulations permit the use of Roth amounts for loans. However, if the loan becomes a deemed distribution, the earnings on the Roth amount would be subject to taxation. Thus, if loans are to be permitted, a policy permitting the loan amount to be based on the Roth vested account balance, but actually permitting the loan only from non-Roth sources is recommended.

Hardship Withdrawals. Roth accounts are subject to the withdrawal restrictions of any elective deferrals. Roth accounts may be made available for hardship distributions. However, strangely enough, the proposed regulations state that if a hardship distribution of Roth amounts is actually taken it would be taxed as if it consisted of a pro rata amount of Roth after tax amount and earnings, which would be subject to taxation and the 10% penalty. In addition, if applying for a future hardship, the Roth amount distributed, including the earnings taxed would be used to reduce the amount of total deferrals when determining the amount of deferrals available for a hardship distribution.

Corrective Distributions. The correction of excess deferrals by a participant that contributed both pretax deferrals and Roth deferrals will follow the same correction rules as have been in place for pretax deferrals. However, in addition, the plan may permit the participant to specify whether the excess deferrals being returned are pretax or Roth deferrals. Allowing the participant to choose while being an option in a plan will not likely be the default. If Roth contributions are returned by April 15 following the year made, only the earnings will be taxed. Even if the 5-year rule and age 59½ requirement have been satisfied, the regulations clearly state that that return of excess deferrals may never be considered a qualified distribution. Gap period income is to be calculated. If returned after April 15th, the Roth amount plus earnings is taxable at the time of distribution as if they were employer and not participant contributions.

Excess distributions and excess aggregate distributions may be made with Roth contributions which have already been included in income. Gap period income is to be calculated and the refunded earnings on the excess are taxable.

Employer securities. If the Roth account contains employer securities with net realized appreciation, and they satisfy the qualified distribution rules, then the employer securities received would not be subject to ordinary or capital gains taxation on the fair market value on the distribution date. Appreciation after the qualified distribution would be subject to capital gains.

If the distribution of employer securities is not a qualified distribution, the Roth account distribution is treated separately then any other employer securities distribution but it is subject to the normal net unrealized appreciation rules of the Code found in section 402(e)(4).

Beneficiaries and alternate payees. If separate accounts are established for an alternate payee or for the benefit of different beneficiaries, each separate account will be treated as a separate contract under Section 72. When the account is established for the alternate payee or beneficiary(s), each must receive a proportionate amount attributable to the investment in the contract. Q&A-9

Final Regulations. We have presented the highlights of these proposed regulations. As already stated we will present a discussion of the rollover issues in a future article. Additionally, as hearings on these regulations are held we will discuss the concerns addressed at those hearings. As soon as they are finalized, we will discuss the final regulations.
Proposed Roth Distribution Regulations

Roth 401(k) Final Regulations Article

Bill Grossman, QPA