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Roth 401(k) Knowledgebase

Compliance and Recordkeeping

Plans that include a Roth 401(k) feature have specific plan qualification, recordkeeping, and administration (compliance) requirements as discussed below.

Roth 401(k) Elective Deferral Treatment Elective deferrals made to a Roth 401(k) account are treated the same as pre-tax 401(k) deferrals for all compliance and testing purposes, including:

§   Maximum Dollar Limits (the lesser of 100% of compensation, or $16,500 for 2010 (and indexed in future years) - IRC §402(g) and IRC §401(a)(30)

§   Catch-up Limits (the lesser of 100% of compensation minus any other 401(k) contributions, or $5,500 for 2010 (and indexed in future years) - IRC §414(v)

§   100% Immediate Vesting Requirement - IRC §401(k)(2)

§   Distribution Restrictions - IRC §401(k)(2) and Tres. Regulation §1.401(k)-1(d)

§   ADP Testing - IRC §401(k)

§   General Nondiscrimination Average Benefits Testing - IRC §401(a)(4)

§   Minimum Coverage Average Benefits Testing - IRC §410(b)

§   Top Heavy Determination - IRC §416

§   Qualified Joint and survivor Annuity Rules - IRC §401(a)(11)

§   Annual Additions Limit (the lesser of 100% of compensation, or $49,000 for 2010 (as indexed) - IRC §415

§   Employer Deduction Limit (exemption from 25% of covered compensation limit) - IRC §404(n)

Separate Accounting  The Roth 401(k) account must be separate and distinct from the pre-tax 401(k) or any other participant accounts including voluntary after-tax contribution accounts. Separate recordkeeping of the cumulative contributions (the “principal” or “basis”) and earnings facilitates distributions in a manner that is distinct to Roth 401(k) accounts. See Distinctions between Roth 401(k) and Roth IRA

This recordkeeping requirement (tracking the principal amount of the contribution) is the same as is currently necessary to determine the maximum pre-tax 401(k) hardship distribution; however, administration systems must have the available fields to add the Roth 401(k) account. The Roth 401(k) account must have separate fields for contributions and interest to facilitate determination of availability for distributions, compliance testing, and distribution reporting purposes while also having the capability to combine the fields for year-end reporting.

Ordering Rules  Administrative procedures, and possibly plan language, are required to determine the order for refunding pre-tax and Roth 401(k) contributions (and catch-up contributions) with regard to the taxation of corrective distributions resulting from ADP testing failures, refunds of contributions that exceed the §402(g) limit, and deemed distributions resulting from loan defaults.

The regulations provide that the HCE participant may designate the order in which refunds are made from each respective money type (pre-tax first, Roth first, or both proportionately; also see discussion under “Forms”). As a practical matter, ordering rules are typically specified in the plan document to facilitate system programming and mitigate processing errors.

Distributions for Loans, In-service, Hardship and QDROs  The money type from which distributions occur impacts the taxation of the distribution. Therefore, policies and forms that affect these distributions must address the distinction between Roth and pre-tax accounts.  Distributions specified from a Roth account may result in a significantly different outcome than anticipated dependent on the tax status (qualified or nonqualified) of the distribution.

Refund of Excess Contributions  If a plan’s ADP Test fails, HCEs may receive a refund representing the excess contribution. The principal amount of any Roth 401(k) contribution refund is not taxable.  However, any investment gains may be, if that portion of the distribution would not satisfy the rules to qualify for tax-free status. If the HCE contributes to both the Roth and the pre-tax accounts, the regulations permit the HCE to designate the money type from which the refund is processed. However, as previously stated, as a practical matter, plans typically designate ordering rules for refunds. The same rules apply to refunds of excess aggregate contributions if a refund to cure a failed ACP test includes elective deferrals.

Automatic Rollovers  If a plan contains mandatory cash out provisions for account balances exceeding $1,000, an automatic rollover to an IRA is required when a participant’s account balance is between $1,000 and $5,000, and the participant has not made an affirmative election to either roll over or take a taxable distribution. If the participant’s account consists of both Roth and pre-tax monies, each respective money type must be rolled over into the appropriate type of IRA. If the total account balances equals $1,001 but the amount from each respective money type is less than $1,000, the plan administrator must be mindful that certain IRA custodians do not accept small amounts that are below the threshold stated in their service agreement.

Automatic Enrollment  If the plan contains an automatic enrollment feature, forms and procedures may need to be modified if the automatic enrollment involves Roth 401(k) contributions.

Payroll System Issues

Salary Deferrals  The calculation of the federal income tax withholding from the Roth 401(k) deferral is not likely an issue for most payroll systems in that the calculation is the same as any other after-tax payroll deduction, such as loan repayments to the plan. However, although the payroll system may have the tax calculation capability, that does not mean it can properly accommodate Roth contributions (e.g., no available field, system limitation).

Individual and Catch-up Limits  Payroll systems must consider both the pre-tax and the Roth contributions for purposes of capping salary deferrals at the 402(g) and catch-up contribution limits. This requires the payroll system to have two additional fields available (one each for the Roth 401(k) and the Roth catch-up) and the ability to combine these respective fields with the corresponding pre-tax fields.

Matching Contributions  For plans that calculate matching contributions throughout the plan year on a payroll by payroll basis, the payroll system must take into account both money types (pre-tax and Roth) when applying any percentage or dollar limit cap in the matching contribution formula. The total match is then contributed to the same employer match account.

Reporting Issues  Distributions consisting of both pre-tax and Roth require separate Form 1099-Rs.  For 2008 Roth(k), report the gross amount of the distribution in Box 1; any taxable amount (nonqualified) in Box 2a; any nontaxable amount (the contribution “basis”) in Box 5; and the first year of the 5-year-taxable period in Box 10.  Also enter Code B in Box 7 along with any other applicable code (“1” early distribution, no known exception; “2” exception applies; “4” death; “8” excess contributions plus earnings/excess deferrals (and/or earnings) taxable in 2007; “G” direct rollover; “L” deemed distributions from loans; or “P” excess contributions plus earnings/excess deferrals (and/or earnings) taxable in 2006).  These code(s) apply unless the distribution is due to: a) IRS levy under section 6631, then use Code 2, or b) return of 415 excess, then use Code E.  No instructions exist at this time for 60-day Rollover reporting; therefore, no reporting.

Plan Amendments  Adding the Roth 401(k) contribution feature requires an interim amendment by the end of the plan year in which the option is first effective.  Detailed plan amendments are required when the plan is reviewed for EGTRRA.

Participant Disclosure The new Roth 401(k) feature must be included in all required participant disclosures as discussed below. In addition to the required disclosures, employer/plan sponsors should consider providing additional written communications and holding employee meetings to explain the benefits and features of the Roth 401(k) to existing participants as well as future new plan participants.

Summary Plan Description (SPD) The plan’s SPD (or amendment to the SPD, i.e., the summary of material modifications, or SMM) must provide an explanation of the Roth 401(k) eligibility requirements, tax treatment of contributions and earnings, contribution limits, withdrawal restrictions, and any applicable procedural rules.
“Safe Harbor Notice  The timing of the addition of the Roth feature may be especially important with regard to 401(k) plans that elect “Safe Harbor” status to eliminate ADP and ACP testing. The safe harbor notice must be provided to participants at least thirty days prior to the beginning of the year and must contain a description of the type and amount of compensation that may be deferred. It remains to be seen whether the IRS will provide any transitional relief for plans adding the new Roth feature during 2006.

402(f) Notice  Participants who are entitled to receive a distribution that is eligible for rollover must be provided written notice regarding the participant’s right to roll the distribution over to an eligible retirement plan and any tax implications. If the plan has a Roth 401(k) feature, the notice must reflect those issues that are unique to rollovers from Roth 401(k) accounts. The IRS is expected to issue an updated version of the model IRC §402(f) notice reflecting the appropriate changes for plans with a Roth 401(k) feature before January 1, 2006.  Sample Model 402(f) Notice (Plans with Roth 401(k) Account)

Forms  Depending on the nature of the action required, most, if not all, of the plan administrative forms need modification.

Salary Deferral Agreements need to include the option to contribute all or part of the elective deferral to the Roth 401(k). If an automatic enrollment procedure involves a Roth 401(k) account, the negative election salary deferral form must also reflect the procedure modifications.

In-service Distribution Forms need to include the Roth 401(k) as an available money type, if permitted under the plan.  Distribution Forms need to include the option for a direct rollover of a Roth 401(k) account to a Roth IRA account.

Beneficiary Forms may need to include the option of specifying different beneficiaries for pre-tax and Roth proceeds.
Investment Election Forms may need to permit different asset allocations for pre-tax and Roth accounts.

Refund Election Forms may need to be provided to HCEs who are to receive refunds of excess contributions due to an ADP Test failure. Historically, most plans contain any applicable ordering rules within the plan document to provide hard and fast rules that eliminate any guesswork. While the regulations permit HCEs to choose the money type from which refunds of excess contributions are to be processed, as a practical matter, the ordering rule may ultimately be hard-wired into many plan documents.

Final Roth 401(k) Regulations

Designated Roth Accounts

Section 402A Taxation of distributions from Roth Accounts

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