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Treasury and IRS Issue Roth 401(k) Final Regulations

December 31, 2005

By Barry R. Milberg

The Treasury Department and the IRS issued final regulations under §§401(k) and 401(m) on December 30, 2005 relating to designated Roth contributions.  The regulations finalize the proposed rules issued on March 2, 2005 and are effective January 3, 2006 for plan years beginning after December 31, 2005.

The regulations amend the Income Tax Regulations under §§401(k) and 401(m) of the Internal Revenue Code of 1986 and provide guidance on Roth contributions under IRC §402A, added by §617(a) of EGTRRA.  These changes also apply to the corresponding sections of IRC 403(b)

Background (portions in quotes copied directly from the background to the regulations)

The regulations apply to plans containing a qualified cash or deferred arrangement which permit elective contributions by employees (a "401(k) plan").  "Pre-tax" elective contributions are typically not includible in gross income at the time contributed.  However, "under section 402A, effective for tax years beginning on or after January 1, 2006, a plan may permit an employee who makes elective contributions under a qualified cash or deferred arrangement to designate some or all of those contributions as designated Roth contributions."   These "after-tax" elective Roth contributions are currently includible in gross income.  

After-tax contributions to a Roth 401(k) or Roth IRA are similar in nature with certain specific exceptions, including:

  • Individuals are prohibited from making contributions to a Roth IRA if his/her adjusted gross income exceeds certain limits.  No such income limits apply to an individual's eligibility to make Roth 401(k) contributions;

  • Traditional IRAs may be converted to Roth IRAs, but no such conversion provision applies to pre-tax 401(k) contributions; and

  • Specific ordering rules apply to Roth IRA distributions.  §402A does not provide specific ordering rules for distributions from Roth 401(k) accounts; therefore, the rules under §72 apply to determine the character of distributions from these accounts.

§1.401(k)-1(f) of the 401(k) final regulations issued on December 29, 2004 was reserved for special rules for Roth contributions.  Proposed regulations issued on March 2, 2005 provided §1.401(k)-1(f) language along with additional rules applicable to Roth contributions.  The final regulations adopt the provisions of the proposed regulations with certain modifications discussed below. 

DEFINITION OF DESIGNATED ROTH CONTRIBUTION (indented portion copied directly from the final regulations)

The final regulations amend §1.401(k)-1(f) to provide a definition of designated Roth contributions as elective contributions under a qualified cash or deferred arrangement that are:

(i) Designated irrevocably by the employee at the time of the cash or deferred election as a designated Roth contribution that is being made in lieu of all or a portion of the pre-tax elective contributions the employee is otherwise eligible to make under the plan;

(ii) Treated by the employer as includible in the employee's gross income at the time the employee would have received the amount in cash if the employee had not made the cash or deferred election (e.g., by treating the contributions as wages subject to applicable withholding requirements); and

(iii) Maintained by the plan in a separate account (in accordance with paragraph (f)(2) of this section).

The regulations also provide that elective contributions may only be treated as designated Roth contributions to the extent permitted under the plan.

Significant Modifications (portions in quotes copied directly from the explanation of the regulations)

Plan must permit both Pre-tax and Roth Contributions  The final regulations clarify that a plan offering a Roth option only is not permitted.  §402A(b)(1) provides that: "designated Roth contributions are made in lieu of all or a portion of elective contributions that the employee is otherwise eligible to make under the cash or deferred arrangement.  [Therefore,] If a cash or deferred arrangement offered only designated Roth contributions, an employee participating in the arrangement would not be electing to make such contributions in lieu of elective contributions he or she was otherwise eligible to make under the plan."

Separate Accounting Requirement  The final regulations retain the rule that states: "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 (i.e., designated Roth contributions that have not been distributed) with respect to the employee's designated Roth account.   In addition, gains, losses, and other credits or charges must be separately allocated on a reasonable and consistent basis to the designated Roth account and other accounts under the plan." 

The final regulations retain the rule provided in the proposed regulations which states that forfeitures may not be allocated to Roth accounts.  Further, the final regulations clarify that: "no contributions other than designated Roth contributions and rollover contributions described in section 402A(c)(3)(B) are permitted to be allocated to a designated Roth account."  This means that employer matching contributions cannot be allocated to a Roth account.

Lastly, the final regulations retain the rule that requires separate accounting for the Roth contribution from the time it is contributed to the time it is distributed.

Roth Deferrals Same as Pre-tax   The final regulations retain the requirement that Roth contributions must satisfy the requirements applicable to any other elective contributions made under a 401(k) plan.  This means that Roth contributions must be treated the same as pre-tax contributions with regard to the:

  • 100% immediate vesting requirement;

  • Actual deferral percentage test (ADP test) of section 401(k)(3);

  • Ability to make catch-up contributions;

  • Ability to serve as the basis for a participant loan;

  • Required minimum distributions;

  • Frequency of contribution elections;

  • Automatic enrollment provision of the plan (to the extent which default contributions are pre-tax or Roth);

  • Rollover the Roth account into another plan as described in §402A(e)(1) or a Roth IRA;

  • Automatic direct rollover requirements of the plan;

  • Correction methods that may be used when a plan fails to satisfy the ADP or ACP test for a year.  Ordering rules for the two money types: The final regulations retain the rule in the proposed regulations that permits an HCE (highly compensated employee) to elect whether excess contributions are attributable to pre-tax or Roth contributions.  However, there is no requirement that a plan provide this choice to the HCE.  The plan may provide for ordering rules with regard to such refunds that are necessary as a result of the test failure; and

  • Distribution of excess contributions are not includible in gross income to the extent that it represents a distribution of the Roth contribution (the contribution "basis") whereas income allocable to the contribution is includible in gross income.

Issues NOT Addressed

The final regulations do not provide guidance with respect to the taxation of distributions from a Roth 401(k) account.  These rules will be provided in the proposed regulations under §402A which are to be issued in the near future.

Effective Date

"Section 402A is effective for an employee's taxable years beginning after December 31, 2005.  These regulations have the same effective date as the regulations under section 401(k) that they are amending. Thus, these final regulations are generally applicable to plan years beginning on or after January 1, 2006.  If a plan is applying the section 401(k) regulations as of an earlier effective date (as provided under those regulations), to the extent that section 402A is effective, that same early effective date applies to these regulations.  For a plan that has an effective date for the section 401(k) regulations that is after the effective date of section 402A (either an employer that does not have a calendar year plan or a plan established pursuant to a collective bargaining agreement that has a delayed effective date for the section 401(k) regulations), the employer may rely on these regulations prior to the effective date of the final section 401(k) regulations for the plan, even if the plan does not otherwise implement the section 401(k) regulations earlier than required."

EGTRRA Sunset  The regulations do not provide rules for applying the EGTRRA sunset provision, which state that the Roth option will not apply to taxable, plan, or limitation years beginning after December 31, 2010.  Therefore, absent the repeal of the sunset provision, additional guidance is required to clarify its application.

Closing Commentary  Those employers and plan service providers who sat on the fence awaiting these regulations may be surprised at the outcome.  As Shakespeare might comment: "There's been much ado about nothing!" in that the final regulations bring no surprises or substantive changes to any of the proposed rules. 

We stated our position on these "open" issues long ago by interpreting the law in good faith.  Now that we all can all agree that the rules will evolve as needed (as they always do), we can get down to the task at hand...  Assisting participants with the important decision relative to whether the Roth option is beneficial for their individual needs.

View the Roth 401(k) final regulations