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Treasury and IRS Issue Proposed Regulations for Contributions to and Distributions from Roth 401(k) and 403(b) Plans

January 26, 2006

By Barry R. Milberg

On January 25, 2006, the Treasury and the IRS issued the proposed regulations under IRC §§402(g), 402A, 403(b), and 408A relating to designated Roth accounts.  The proposed regulations impact employer/plan sponsors, participants and beneficiaries in both 401(k) and 403(b) plans, and trustees, owners and beneficiaries of Roth IRAs. 

The proposed regulations under IRC §402A intend to provide comprehensive guidance on the taxation of contributions and distributions to and from Roth 401(k) and 403(b) accounts along with the requisite recordkeeping and reporting requirements for these actions.  The proposed regulations also include amendments to the regulations under §402(g) issued in 1991 to reflect the enactment of §402A while also conforming to the regulations the final §401(k) regulations. 

Lastly, the proposed regulations add a new §1.408A-10 to the existing regulations under §408A for Roth IRAs (§1.408A-1 through 9) issued in 1999 to reflect the interaction between §§408A and 402A.

Specifically, the proposed regulations provide guidance with regard to:

  • The 5-year Rule for Qualified Distributions

  • Taxation of Nonqualified Distributions

  • Rollovers of Roth Contributions

  • Determination of 5-year Taxable Period for Rollovers to Roth IRAs

  • Partial Nonqualified Distributions

  • Distribution of Employer Securities

  • Roth 403(b) Accounts

  • Reporting and Recordkeeping Requirements

  • Roth 401(k) Excess Deferrals and Calculation of Gap Period Income

BACKGROUND

IRC §402A, added to the Code by §617(a) of the EGTRRA, provides the rules for plans that offer participants the option to contribute to a Roth account starting January 1, 2006.

A “designated Roth contribution” is an after-tax elective deferral by an employee to a 401(k) or 403(b) plan.  IRC §402A(b)(2) states that Roth contributions must be maintained by the plan in a separate account (“a designated Roth account”). 

IRC §402(a) provides that distributions from a qualified plan are taxable under section 72 to the recipient in the taxable year received.  IRC §402A(d)(1) provides that qualified distributions from a designated Roth account are tax-free.  IRC §72 provides the rules for taxation of nonqualified distributions from Roth accounts.

IRC §402(c) provides the rules for certain distributions from qualified plans that may be rolled over without any tax consequences into another eligible retirement plan.  IRC §402(c)(2) provides that if some or all of the distribution from a qualified plan (either 401(k) or 403(b)) is not taxable even if it’s not rolled over, then that portion of the distribution can be rolled over only into an IRA, or as a direct rollover to another qualified plan which separately accounts for that specific rollover amount. 

IRC §402(c)(8) and 402A(c)(3) specify that distributions from Roth accounts can be rolled over only to another Roth account or a Roth IRA.  For distributions from Roth IRAs, IRC §408A(d)(4) provides special ordering rules for the tax-free return of the principal amount of the contribution (the “basis”) prior to the distribution of taxable interest. 

EGTRRA §617(d) amended §6051(a)(8) to require the reporting of Roth 401(k)/403(b) contributions on Form W-2, and added a new subsection (f) to section 6047 to require plan administrators of 401(k) or 403(b) plans to make such returns and reports regarding Roth contributions to the Secretary of the Treasury and such other persons the Secretary may prescribe.

The final regulations for 401(k) plans were issued on December 29, 2004 which reserved §1.401(k)-1(f) for special rules for Roth contributions.  Proposed regulations to fill in that paragraph and provide additional rules applicable to Roth contributions were issued On March 2, 2005.  The final regulations which adopted the proposed regulations, with certain modifications, were issued on January 3, 2006.  However, the final 401(k) regulations relative to Roth contributions did not address the taxability of distributions from Roth accounts or the reporting requirements applicable to contributions or distributions.

Commentary  We’ll provide a comprehensive analysis of the specific rules outlined above in a subsequent article.

As with the issuance of the final Roth 401(k) regulations on December 30, 2005, it once again appears that these proposed regulations provide no particular surprises relative to the establishment or ongoing record-keeping and compliance requirements for new or existing plans that add the Roth feature.  Of course, a lot more work is involved in implementing and administering this option, but then again last I checked, that’s what our industry is built for and survives on… change. 

Yes, the Roth is not an easy feature to communicate.  Yes, you need to be careful that what you provide to plan participants is not construed to be tax advice.  However, time will prove that “No,” is not the appropriate answer for most employer/plan sponsors (especially small business employers) to the question of whether the employer should adopt this feature.

It’s not so long ago that the industry was spooked by the recordkeeping requirements to implement “safe harbor.”  Today, safe harbor plans are common-place, so too, in my humble opinion, is the fate of Roth accounts.  The Roth option is the best reason to come along for quite some time that should permit the industry to increase fees for services.  Why… because the Roth provides significant retirement and estate planning opportunities for participants of all ages and income levels.  I can personally attest to the fact that the use of the proper tools and the time commitment to educate your clients relative to the benefits of the Roth is a mutually beneficial experience.  

View the Proposed Regulations for Designated Roth Accounts Under Section 402A

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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 professionalERISA 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.