Designated Roth Accounts
Rev. 08/22/08, E-mail Alert 2008-11

Designated Roth Recap
Designated Roth was created by the Economic Growth and Tax Relief and Reconciliation Act of 2001 (EGTRRA) for tax years after 2005, Specifically, Section 617(a) of EGTRRA created a new section of the Tax Code IRC §402A. Although part of the EGTRRA sunset after 2010, the PPA made designated Roth permanent. Designated Roth accounts are available for deferrals under a §401(k) plan or a §403(b) arrangement and the rules and tax treatment are generally the same.

Regulations on designated Roth accounts were issued in two phases. Final regulations for offering designated Roth were issued December 29, 2005, effective Jan. 1, 2006. Final regulations on designated Roth distributions, rollovers and reporting issued April 27, 2007, generally effective Jan. 1, 2007, though some sections were effective January 1, 2006.

Regulations under §402A are incorporated into the Final §401(k) rules and into the §403(b) regulations. As part of 401(k) final regulations, Roth was able to be incorporated into the EGTRRA 401(k) document.

Designated Roth accounts were first available for Plan Years that begin on or after January 1, 2006. Thus, no designated Roth account is 5-years old at this time. IRS issued sample language for the addition of the Roth provision. An off-calendar plan may add the designated Roth to the plan, but for participants the designated Roth tax year begins January 1.

Adding Roth to Plan
Roth is an optional provision. It is a discretionary amendment. It must be in the plan document in order for the participants to use it. If adding the Roth, it must be done by last day of the first year in which it is used (per IRS Notice 2005-95, Rev. Proc. 2005-66 and Rev. Proc. 2007-44, Section 5.05). Note: IRS issued sample Roth amendment Notice 2006-44.

Adding Roth to a Safe Harbor 401(k) Plan
Per IRS Announcement 2007-59, an employer may add designated Roth to a Safe Harbor 401(k) plan after the plan year has started. This will not spoil the safe harbor, even though the notice was given out.

REQUIRED CONDITIONS
The Final Regulations stipulate three required conditions for contributions to be eligible to be designated Roth contributions.

1. Irrevocable Election
When is a contribution considered to be a designated Roth contribution?
At the time of election as a Roth deferral the deferral is irrevocably designated as a Roth contribution. Unlike an IRA, no change may be made by tax filing deadline.

2. Includible in income
The Roth deferral is to be treated as includible in the employee’s income (not pre-tax). Although a deferral, it is treated as wages subject to withholding and taxation.

3. Separate Account
Designated Roth deferrals must be maintained in a separate account from pre-tax deferrals and other sources. Contributions and distributions must be record kept as separate a Roth source. Gains, losses, expenses, etc. must be separately allocated on a reasonable and consistent basis. No forfeitures may be allocated to a Roth.

BENEFITS AND ATTRIBUTES OF ROTH DEFERRALS
1. Tax Free Earnings
Roth deferrals are included in income (this is not a benefit) but if left in plan until a qualified distribution, the earnings will be distributed tax FREE!
2. W-2 Reporting
The designated Roth contribution is included in taxable income and is reported as a deferral; whereas, pretax deferrals are excluded from gross income.

W-2 Box 12 Codes
Roth = Code AA, plus amount of Roth deferrals
Pretax = Code D, plus amount of pretax deferrals

3. Deferral Limit
“Roths” are subject to the annual deferral limit, for 2008 = $15,500, plus catch-up (for those over age 50) of $5,000. As compared to 2008 IRA Roth limit of $5,000 plus $1,000 in catch-up.

Example 1
Plan Year = 2009
Plan = Piggy Bank, Inc. 401(k) Plan
Features = Roth deferral, Pre-tax and Catch-up
Participant = Mack, age 51
Defers = $16,500 as Roth and $5,500 as Catch-up (also as a Roth)
Note: Catch-up may be designated as Roth

Example 2
Plan Year = 2009
Plan = Piggy Bank, Inc. 401(k) Plan
Features = Roth deferral, Pre-tax and Catch-up
Participant = Jen, age 55
Defers = $10,250 as Roth, $10,250 as Pre-tax
(Salary deferral agreement completed: 50% in Roth and 50% in pre-tax deferrals)

Roth IRA and Designated Roth
Contributions to an IRA (even a Roth IRA) will not affect this limit.

Example
In 2009, Matt (age 35) contributes $16,500 in his Roth 401(k) plan and $5,000 in his Roth IRA.
Roth IRA has income limitation,
- Married filing joint: MAGI $166,000
- Single: MAGI $114,000
Note: the Roth IRA has been around since 1998.

4. 401(k) Advantages Compared to Roth IRA
A. Eligible employees may find the fee structure in a 401(k) plan to be better than in a Roth IRA.
B. Designated Roth may receive match.
C. No income limitations for eligibility to contribute to designated Roth (Roth IRA has income limitations). Therefore, higher income employees will be able to contribute.

5. Tax-free Earnings
As indicated earlier – if amounts meet the 5-year and age 59 1/2, death or disability requirement, they will be a “qualified distribution” (tax-free)

OPERATIONAL ISSUES
1. Roth Treated as Elective Deferrals
Roth deferrals are treated as elective deferrals under the terms of the plan and document for:

• Contribution limits
  
• ADP testing
  
• Matching formulas
  
• Vesting, 100% vested
  
• Nondiscrimination
  
• Coverage
  
• Top heavy
  
• QJSA, $5,000 consent and cash out rule combined
  
• 415 annual additions
  
• RMDs
  

2. Participant Must Designate as Roth
The participant must designate the contribution as a Roth prior to deposit to the plan. Roth needs to be explained at enrollment meetings and on enrollment forms. Roth must be included in the Summary Plan Description.

3. Automatic Enrollment
Automatic Enrollment plans may default deferrals as Roth. Prior to the first dollar being deferred, participants will have the right to opt out or change their deferral.

4. Pre-Tax and Roth Required
The plan must offer pre-tax deferrals along with the Roth. “Roth only” plans are not permitted by the regulations.

5. Some or All as Designated Roth
If plan design allows – some or all of deferrals can be designated as Roth. On a prototype, employers may not limit the amount/percentage of deferrals for Roth versus pre-tax deferrals, other than for plan not to offer the Roth.

6. Changes in Deferrals
The flexibility to change from Roth to pretax deferrals or to change the amount of deferral is a plan design issue. The regulations only require that a participant have the ability to change Roth elections as often as pre-tax, and per regulations at least once a year. Of course, deferrals may be stopped at any time.

7. Matching on Roth
Matching funds associated with Roth deferrals will be treated as pre-tax.

8. No Conversion of Pre-Tax to Roth
Pre-tax §401(k) balances are not allowed to be converted to a Roth account. Unlike their distant IRA cousins, deferrals may not be converted from pretax to after-tax.

9. 403(b) Universal Availability Requirement
In §403(b) arrangements, the universal availability rule will apply. Thus, if a Roth is offered to any 403(b) plan participants, it must be offered to all plan participants.

QUALIFIED DISTRIBUTIONS

Distribution is “qualified” if the designated Roth account has satisfied the 5 year requirement, AND the distribution is made:

• After attainment of age 59½, or
  
• After the death of the participant, or
  
• If the participant is disabled.
  

Any other distribution is treated as nonqualified

Example 1
Julie first made a Roth deferral in 2006. She leaves her company in 2012 at age 50. Julie requests a distribution. This is a nonqualified distribution. Although the funds have been in the plan for more than 5 years, the age 59½ requirement was not met.

Example 2
Sally first made a Roth deferral in 2006. She leaves her company in 2009 at age 65. Sally requests a distribution. This is a nonqualified distribution, although Sally has satisfied the age 59½ requirement, the 5-year period did not elapse.

Example 3
Lizzie first made a Roth deferral in 2006. Lizzie dies in 2009 at age 62. The beneficiary requests a distribution in 2008. This is a nonqualified distribution. Although Lizzie has satisfied the age 59½ requirement and the distribution is because of death, the 5 year period did not elapse.

Example 4
Rita first made a Roth deferral in 2006. Rita severs employment in 2012 due to disability that satisfies Code Section 72(m)(7). Rita is age 45 and she takes a distribution in 2012. This is a qualified distribution. Although Rita has not satisfied the age 59½ requirement, the distribution is qualified because: Disability that meets Section 72(m)(7), and the 5-year period did elapse.

Beneficiary or Alternate Payee
Clarification under the final distribution regulations states that the age, death or disability of the participant is used to determine whether a distribution is qualified in the case of an alternate payee or a beneficiary.

Exceptions: If the alternate payee or surviving spouse rolls money to their own Roth account, then you base the qualified status on their information

Example
If a participant dies in 2009 and the surviving spouse leaves the funds in the plan until 2013 – the five-year rule will have been satisfied and the distribution will be tax-free.