Roth 401(k)s Heat Up as the IRS Begins to Issue Guidance

What is a Roth 401(k)? A Roth 401(k), or a designated Roth contribution program, is a new type of employee contribution that Internal Revenue Code (IRC) Sec. 401(k) plans can incorporate for plan years beginning on or after January 1, 2006.  This program was originally introduced by the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), and has the potential to gain momentum in the coming months as the effective date approaches and the IRS releases additional operational guidance. (Designated Roth contribution provisions can be adopted by IRC Sec. 403(b) plans, as well. Because no 403(b) plan guidance on Roth contributions has been released, this article will address only Roth 401(k) provisions.)

A designated Roth contribution program will give 401(k) plan participants the opportunity to defer some of their wages into a 401(k) plan as Roth contributions.  Distributions can result in tax treatment similar to distributions from Roth IRAs, which have become enormously popular. Roth 401(k) contributions will be included in a participant’s income and will be taxed in the year the contributions are made, but qualified Roth 401(k) distributions (including earnings) will be tax-free.  Some key advantages of Roth 401(k) contributions, as opposed to Roth IRA contributions, are that eligibility to make contributions is not restricted by a participant’s income level, and the contribution limits are higher.  Subject to the terms of a 401(k) plan, the most a participant can contribute as Roth 401(k) contributions for 2006 is $15,000, plus up to $5,000 in catch-up contributions if age 50 or older—the same contribution limits that apply to pretax elective contributions (deferrals).  This maximum limit applies to Roth 401(k) contributions and pretax 401(k) contributions in aggregate.

The Roth component of a 401(k) plan may appeal to many employees because it has the potential to increase retirement benefits. The ultimate benefit of Roth 401(k) contributions will depend upon the amount of earnings they generate, how long the assets stay in the account, and an individual’s tax rate at the time contributions and distributions are made.

Proposed Regulations

On March 2, 2005, the IRS released proposed regulations (REG-152354-04) that address Roth 401(k) contributions.  These regulations represent the first operational guidance since the concept was introduced by EGTRRA, which codifed the Roth contribution program under IRC Sec. 402A.  REG-152354-04 proposes to amend the final IRC Secs. 401(k) and 401(m) regulations to add provisions governing Roth 401(k) contributions.  As with all proposed regulations, the IRS is requesting written comments, which must be received by May 31, 2005.

General Rules

IRC Sec. 402A and REG-152354-04 indicate that a 401(k) plan may permit participants to make Roth contributions in addition to or instead of pretax elective contributions. Roth 401(k) contributions will be included in a participant’s gross income in the year contributed. A qualified distribution of Roth 401(k) contributions (including earnings attributable to those contributions) will be excluded from gross income in the year distributed.

REG-152354-04 defines Roth 401(k) contributions as contributions under a qualified cash or deferred arrangement (CODA) that are

  • Designated irrevocably as Roth contributions by the participant at the time of the CODA election,
  • Treated by the employer as includible in the participant’s wages at the time the participant would have received the contributions in cash if not contributing them to the plan, and 
  • Maintained in separate accounts.

As suggested by REG-152354-04, the irrevocable election to treat elective contributions as Roth contributions will not permit plan participants to later claim that contributions should have been pretax deferrals.  The proposed regulations also clarify that the employer must treat Roth 401(k) contributions as wages subject to withholding requirements.

A plan must separately account for Roth 401(k) contributions. The proposed regulations clarify that Roth contributions and distributions must be credited and debited to a participant’s Roth account, and that a plan must maintain a record of the basis (contributions) and earnings within a Roth account. Earnings, losses and other credits or charges applicable to Roth contributions must also be separately allocated to a participant’s Roth 401(k) account.

Other Clarifications

Although the tax treatment of Roth 401(k) distributions appears to mimic the tax treatment of Roth IRA distributions, Roth 401(k) contributions and distributions must generally satisfy the same requirements as pretax elective contributions in a 401(k) plan.  For example, Roth 401(k) contributions are treated as elective contributions under the terms of the plan and, therefore, are 100 percent vested.  Additionally, Roth contributions must satisfy the distribution requirements applicable to elective contributions, including the distribution triggers defined in the plan (e.g., termination of employment, death, disability, etc.) and required minimum distributions under IRC Sec. 401(a)(9).

Other rules for Roth 401(k) contributions include the following

Forfeitures—Forfeitures that are typically allocated to participants’ accounts in a retirement plan may not be allocated to Roth 401(k) separate accounts.

Rollovers—Roth 401(k) assets may only be rolled over either to another designated Roth account or to a Roth IRA.

Distributions—Although Roth 401(k) assets may only be distributed when a participant meets a distribution trigger under the plan, this does not necessarily mean that the Roth assets will be distributed tax-free. Roth 401(k) assets must also satisfy certain qualified distribution requirements under IRC Sec. 402A(d)(2). Specifically, a distribution of Roth 401(k) assets will be considered qualified only after a five-year requirement is met, and if the participant reaches age 591/2, dies or becomes disabled.

Distributions taken within the five-year period, referred to as the “nonexclusion period,” may subject the earnings to taxation.  This five-year period begins with the earlier of

  • The first taxable year for which the participant made Roth contributions to the distributing retirement plan, or
  • The first taxable year the participant made Roth contributions to a former employer’s retirement plan, which was rolled over to the distributing retirement plan.

ADP Testing

Roth 401(k) contributions must be included in the actual deferral percentage (ADP) test, as well as in other required tests (e.g., top-heavy, annual additions, etc.), in the same manner as pretax elective contributions. REG-152354-04 indicates that, when correcting an ADP test failure, a plan may permit a highly compensated employee who has made both Roth contributions and pretax elective contributions in the applicable year to choose whether the distribution of excess contributions will consist of Roth contributions or pretax contributions. Roth 401(k) contributions that are distributed as corrective distributions are not qualified distributions.  Contribution amounts (basis) will not be taxable to the participant, but earnings included in the distribution will be. Similar rules apply for a distribution of excess aggregate contributions as a result of an actual contribution percentage (ACP) test failure.

Summary

The proposed Roth 401(k) regulations do not address all possible aspects of a designated Roth contribution program. For example, the proposed regulations do not provide specific guidance on distribution ordering rules or taxation of nonqualified Roth 401(k) distributions.  Further, the proposed regulations clearly indicate that a plan must include Roth contribution language in the plan document before Roth contributions can be made under the plan. However, the IRS has not yet released any amendment requirements.  Before issuing final regulations, the IRS is seeking comments on any issues that arise from IRC Sec. 402A for which guidance is needed.  Document sponsors and employers should prepare to spring into action once amendment guidance is released, as Roth 401(k) contributions are expected to be quite popular with many 401(k) plan participants.

For further questions contact your BISYS Customer Service Representative.

Also available – Roth 401(k) Telephone/Web seminar, June 8th at 1:30pm and June 22nd at 11:00am (Note: times are Central Time Zone).

Online registration available at http://www.bisysretirement.com/