Detailed Analysis of Proposed Regulations for Distributions from Roth 401(k) and 403(b) Plans
February 8, 2006
A Roth account is defined as an account in a 401(k) or 403(b) plan that must separately account for contributions, gains, and losses. The proposed regulations clarify that any transaction or accounting methodology that has either a direct or indirect impact on the separate accounting of the Roth account is in direct violation of §402A.
The proposed regulations are effective for plan years beginning on or after January 1, 2007 except as otherwise noted below. However, in that §402A is effective for plan years beginning on or after January 1, 2006, a good faith interpretation of the statute is required for operating plans with a Roth feature in the 2006 plan year.
Our January 26, 2006 article provides the background for these proposed regulations. Learn more
This article provides a detailed analysis of the proposed regulations with regard to the following Roth related issues:
5-year Rule for Qualified Distributions
A tax-free distribution from a Roth account must satisfy both the qualified purpose and the 5-year rule (both, not either/or). The proposed regulations reflect the rule in §402A that the 5-taxable-year period during which a distribution is not a qualified distribution (a nonqualified distribution) begins on the first day of the taxable year in which the employee first contributed to the plan (the start year of the "5-year clock") and ends after the passage of 5 consecutive taxable years. This means that a contribution made at any time during a taxable year (e.g., on December 31) constitutes a year for purposes of this 5-year rule.
Further, the proposed regulations provide that the direct rollover of a Roth account from one plan to another plan (and not to a Roth IRA) preserves the start year for the 5-taxable-year period from the original plan. This means that a new 5-year clock starts if an employee changes employers and does not transfer the original Roth account to his/her new employer's plan.
As further explained below under "Determination of 5-year Taxable Period for Rollovers to Roth IRAs," a new 5-year qualification clock starts for a Roth IRA that receives the proceeds from a Roth 401(k) account even if the 5-year requirement was satisfied in the plan account; however, if the rollover is qualified, the new 5-year clock applies to the gains on the rollover only.
Lastly, Q&A-4(c) of the proposed regulations clarifies that the start of a new 5-year period is not required when a rollover to a Roth IRA results from death or a divorce.
Taxation of Nonqualified Distributions
Many practitioners commented that they wanted the ordering rules in §408A(d) for Roth IRAs, which provide for the tax-free distribution of the contribution principal on a "first in, first out" basis, to be applied to distributions from Roth 401(k)/403(b) plan accounts. However, even though Roth 401(k)/403(b) plan and Roth IRA accounts are similar in nature relative to after-tax contributions and tax-free distributions, the proposed regulations make it clear that these arrangements are not the same in all aspects, especially with regard to the taxation of nonqualified distributions. Specifically, in that §402A does not provide for the same ordering rules as Roth IRAs, the rules under §72 apply to nonqualified distributions from Roth 401(k)/403(b) plan accounts.
Therefore, a distribution from a Roth 401(k)/403(b) plan account that is not a qualified distribution is taxable to the recipient under §402 (or §403(b)(1)), which treats the Roth 401(k)/403(b) plan account as a separate account under §72.
Rollovers of Roth Contributions (effective for plan years beginning on or after January 1, 2006)
The proposed regulations provide that the income limits for contributions for Roth IRAs do not apply to Rollovers from Roth 401(k)/403(b) accounts. Permissible Rollovers are:
Rollovers from Roth IRAs to a Roth 401(k), a Roth 403(b) or a separate rollover account in any 401(a) plan are not permitted (IRC §402A(c)(3)(B)).
Table of Rollover Options
Determination of 5-year Taxable Period for Rollovers to Roth IRAs
IRC §§402A and 408A provide different rules for satisfying the 5-year rule. As discussed above, §402A requires the start of a new 5-year clock if an employee leaves a previously started Roth 401(k)/403(b) account in a prior employer's plan. The clock continues to tick based on the original taxable year in which the employee first contributed to his original employers plan if, and only if, the original account is transferred via a direct rollover to the new employer's plan. For Roth IRAs, §408A provides that the 5-year clock begins with the first taxable year in which a contribution is made to any Roth IRA.
The proposed regulations provide that the 5-taxable-year periods described in each of these respective situations are determined independently of each other. Therefore, if a distribution from a Roth 401(k)/403(b) account is rolled over to a Roth IRA, a new 5-year clock starts as of the taxable year of the rollover. However, if the rollover is made into a previously established Roth IRA (or any other Roth IRA exists, even if it results from another Roth 401(k)/403(b) account distribution), the rollover's satisfaction of the 5-year rule is now based on the 5-year clock of any existing Roth IRA.
If a nonqualified distribution from a Roth 401(k)/403(b) account is rolled over into a Roth IRA, the rollover is now subject to the distribution rules for Roth IRAs. Therefore, the portion of the distribution that represents the contribution principal (the basis) is distributable tax-free assuming that the employee satisfies the qualified purpose rule or the distribution is attributable to a first-time home buyer exception (subject to a $10,000 limit).
The proposed regulations also provide that if a qualified distribution from a Roth 401(k)/403(b) account is rolled over into a Roth IRA, the entire amount of the distribution is treated as basis in the Roth IRA. Therefore, subsequent distributions from the Roth IRA in the amount of the rollover would be treated as a tax-free return of basis regardless of whether the Roth IRA satisfied the 5-year requirement. Any gains on the qualified rollover are taxable based on the 5-year clock of the recipient Roth IRA.
Commentary If you are amongst those who believe that the start of a new 5-year clock when rolling over into a Roth IRA is not sound, then consider that in most instances, the Roth money will not be the pensioner's exclusive source of income starting at retirement. If any of the Roth money is needed, the basis (the total of the contributions only, not any gains) is distributable from a Roth IRA tax-free, and as a practical matter, by the time the pensioner does need to draw upon the Roth IRA account, the gains will likely qualify under the 5-year rule.
In addition, the proposed regulations do provide that the entire rollover (not just the contributions) of a qualified distribution from a Roth 401(k)/403(b) account is immediately treated as basis in the Roth IRA.
Partial Nonqualified Distributions
Treasury Regulation §1.402(c)-2, A-4, provides a listing distributions that are not eligible for rollover and are therefore considered taxable distributions. The proposed regulations provide that these same amounts may not be qualified distributions. This applies to:
Loans and Hardship Distributions
Loans The regulations permit the aggregation of the Roth account with other plan accounts in determining the maximum permissible loan (Q&A-12). However, as stated above, deemed distributions resulting from a loan default from a Roth account are fully taxable. Therefore, the employer/plan sponsor may wish to consider restricting loans from Roth accounts, even though the Roth account is considered in determining the maximum permissible loan.
Hardship Distributions Roth contributions are treated the same as pre-tax deferrals for elective deferral and other qualification purposes. Therefore, the total principal of all pre-tax and Roth 401(k) contributions is considered in determining the maximum permissible hardship distribution. The proposed regulations provide that the total amount of the distribution is treated as reducing the maximum whether or not a portion of the distribution is considered a taxable distribution of income from a Roth account (Q&A-8(a)). In the case of a hardship withdrawal from a Roth account, the distribution is treated like any other nonqualified distribution. This means that a proportionate amount of the distribution is taxable even though any gains on the Roth account are not considered in determining the maximum hardship (Q&A-8(b)).
Distribution of Employer Securities
The proposed regulations provide rules relating to the distribution of employer securities and the application of the net unrealized appreciation election of §402(e)(4). If a qualified distribution includes employer securities, the distribution is not includible in gross income and the basis of each security is the fair market value of the security as of the date of the distribution. Any post distribution appreciation is subject to capital gains treatment. If a distribution of employer securities is not a qualified distribution, the rules of §402(e)(4) apply in the same manner as other distributions except that the Roth 401(k)/403(b) account is treated separately.
Roth 403(b) Accounts
The proposed regulations amend the 2004 proposed §403(b) regulations to reflect the provisions of §402A. In general, the proposed regulations incorporate the basic, definitional and taxation rules for a Roth program in Treasury Reg. §1.401(k)-1(f) into the 2004 proposed regulations under §403(b). They further clarify that the taxation and rollover rules of §402(c)(2) also apply to distributions from 403(b) plans.
However, one issue that remains unique to 403(b) plans is the interaction between the right to make a contribution to a Roth account and the universal availability requirement (§403(b)(12)(A)(ii)). The proposed regulations provide that the universal availability requirement includes the right to make Roth contributions. Therefore, if any employee has the opportunity to contribute to a Roth 403(b) account, then all employees must be afforded this same opportunity. The proposed regulations do not address any other rights with respect to 403(b) elective deferrals that are also subject to the universal availability requirement.
Contribution Basis and 5-taxable-year period The plan administrator or other responsible party is required to keep records relative to each employee's contributions to a Roth account (the principal amount of the contributions or "basis," plus any gains) and the 5-taxable-year period that starts with the first taxable year of contributions.
Rollovers The plan administrator or other responsible party is required to provide the recipient plan with a statement indicating that the rollover is qualified, or a statement that indicates the first year of the 5-taxable-year period and the portion of the rollover attributable to basis. If the distribution is not a direct rollover to a Roth account under another eligible plan, the plan administrator or responsible party must provide to the employee, upon request, this same information. However, in this instance, the statement need not indicate the first year of the 5-taxable-year period. The statement must be provided within a reasonable period following the direct rollover (or employee request), but in no event later than 30 days following the direct rollover (or employee request).
The proposed regulations provide that the plan administrator or other responsible party for the recipient plan is permitted to rely on these statements.
W-2, 1099 and 8606 Reporting The same reporting requirements that apply to other qualified plans also apply to plans with Roth accounts. A contribution to and a distribution from a Roth account is reported on Form W-2 and Form 1099-R, "Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRA, Insurance Contracts," respectively, in accordance with the instructions thereto. A change in the instructions to Form 1099-R is anticipated to require that a separate Form 1099-R be used to report the amount of a distribution from a Roth account, the taxable amount with respect to the distribution, and the first year of the 5-taxable year period.
Employees have no reporting requirements with respect to Roth 401(k)/403(b) contributions. However, if an employee rolls over a distribution from a Roth account to a Roth IRA, he/she must keep track of the amount rolled over in accordance with the instructions to Form 8606, "Nondeductible IRA."
Roth 401(k) Excess Deferrals and Calculation of Gap Period Income
§402(g) treats Roth contributions as elective deferrals even though they are made on an after-tax basis. Therefore, if the total elective deferrals for the year exceeds the 402(g) limit, the excess amount can be distributed by April 15 of the following year without any adverse tax consequences.
If the excess deferrals are not distributed by April 15 of the following year, the proposed regulations provide that gap period income is calculated based on the rules for a distribution of excess deferrals under §402(g), and the distribution plus the gap interest income is taxable, even if all or part of the the distribution would have been tax-free.
Commentary Practitioners we've spoken with expressed some concern over the separate accounting requirement for Roth accounts. They are concerned that Roth contributions must be kept in a totally separate physical account. The final regulations for plans with Roth accounts state: "under the separate accounting requirement, contributions and withdrawals of designated Roth contributions must be credited and debited to a designated Roth account maintained for the employee and the plan must maintain a record of the employee's investment in the contract..." Therefore, the regulations are clear that separate accounting is required but there is no requirement for a totally separate physical account.
The proposed regulations clarify certain rules that generally apply to plan years beginning on or after January 1, 2007. During plan year 2006, employer/plan sponsors are required to operate their plans based on a good faith interpretation of the statute. However, these proposed regulations provide a clear and relatively easy path to follow. Therefore, for most employer/plan sponsors, following the proposed regulations is likely the simplest (and certainly the most prudent) way to operate their plans.
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The information provided is intended as a general resource, not as investment or retirement planning, or legal plan compliance advice or counsel. If you consider any actions discussed in this update, we suggest that you consult a qualified planning, tax or ERISA professional. ERISA Expertise LLC and Barry R. Milberg do not warrant and are not responsible for any errors and omissions from this update. Any tax advice included in this written or electronic communication is not intended or written to be used, and it cannot be used, by the taxpayer for the purpose of avoiding any penalties that may be imposed on the taxpayer by any governmental taxing authority or agency.