January 4, 2006 – In typical fashion, the IRS ended 2005 with a flourish by issuing one last piece of guidance. On December 30, 2005, the IRS issued much-anticipated final Roth 401(k) regulations. These regulations provide guidance on designated Roth contributions (under Internal Revenue Code (IRC) Sec. 402A) to qualified cash or deferred arrangements (CODAs) described in IRC Secs. 401(k) and (m). As expected, these final regulations did not answer the technical distribution and taxation questions that the retirement plan industry is still eagerly awaiting. Instead, the regulations generally just restate and clarify the contribution rules set forth in the proposed regulations (issued in March 2005). The IRS has again stated, however, that it will release additional proposed regulations to address taxation and distribution issues “in the near future.”
The final Roth 401(k) regulations have the same effective date as the final 401(k) regulations they amend—January 1, 2006. For noncalendar year plans, an employer may rely on these regulations before the effective date of the 401(k) regulations for the plan, even if the plan does not otherwise apply the 401(k) regulations earlier than required. These regulations do not address the sunset provision contained in the Economic Growth and Tax Relief Reconciliation Act of 2001, which introduced the designated Roth contribution program. Under the sunset provision, the provisions of EGTRRA generally will expire after December 31, 2010. Thus, unless EGTRRA provisions are extended by repealing the sunset clause, additional transition guidance will be needed.
IRC Sec. 402A Recap
A plan may permit an employee who makes elective contributions under a 401(k) plan to designate some or all of those contributions as designated Roth contributions. Designated Roth contributions are elective contributions that, unlike pretax contributions (i.e., deferrals), are currently includible in gross income. A qualified distribution of designated Roth contributions is excludable from gross income.
Although the tax-free nature of qualified distributions is similar to tax treatment of qualified Roth IRA distributions, many other aspects of designated Roth contributions are not similar to Roth IRA rules. For instance, IRC Sec. 402A does not impose any income limitations for eligibility to make designated Roth contributions, nor does it provide for conversions of pretax elective contributions to a designated Roth account. Also, there are no specific ordering rules for distributions from designated Roth accounts as there are for Roth IRAs. So, it appears that the sometimes complicated distribution rules under IRC Sec. 72 apply until we receive IRS guidance on Roth 401(k) distributions.
Final Roth 401(k) Contribution Regulations
Designated Roth Contributions -The final regulations define designated Roth contributions as elective contributions under a CODA that are 1) designated irrevocably as Roth contributions by the participant at the time of the CODA election, 2) 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 3) maintained in separate accounts. Because designated Roth contributions are made in lieu of all or a portion of pretax elective deferrals, the final regulations clarify that a 401(k) plan must offer pretax elective contributions if it is also going to provide participants the opportunity to make designated Roth contributions. In other words, a Roth-only 401(k) plan cannot exist.
Separate Accounts – The final regulations retain the rule (contained in the proposed regulations) that designated Roth contributions, Roth contribution rollovers, distributions, gains, losses, and other charges must be credited and debited to a separately maintained designated Roth account. The final regulations clarify that employer matching contributions, forfeitures, and other non-Roth contributions cannot be allocated to a designated Roth account. A plan must apply separate accounting at the time designated Roth contributions are contributed to the plan and must maintain a record of basis in the plan until the designated Roth account is completely distributed.
Requirements Applicable to Elective Contributions – The final regulations also require that designated Roth contributions satisfy the requirements that apply to other 401(k) plan elective contributions. Specifically, Roth contributions are 1) nonforfeitable, 2) included as deferrals when performing the actual deferral percentage (ADP) test, and 3) subject to the required minimum distribution (RMD) rules and other distribution restrictions that apply to deferrals. Additionally, the final Roth regulations clarify that designated Roth contributions may be treated as catch-up contributions and may serve as the basis for a participant loan.
Rollovers – The final regulations clarify that a direct rollover from a designated Roth account may only be made to another designated Roth account under a 401(k) plan or a 403(b) plan, or to a Roth IRA—and only to the extent a direct rollover is normally permitted under the rules found in IRC Sec. 402(c). Also, when determining whether a direct rollover option applies (for account balances over $200), a plan is permitted to treat the balance in the participant’s designated Roth account and the participant’s other accounts under the plan as accounts held under two separate plans. Therefore, if a designated Roth account balance is less than $200, the plan does not have to combine other plan account balances with the Roth balance in determining whether the $200 threshold is met.
Participant Elections – The final regulations also clarify that the rules regarding making and changing elections that apply to pretax deferrals also apply to designated Roth contributions. The final regulations confirm that plans may apply automatic enrollment in conjunction with designated Roth contributions. Under the final regulations, a plan that has both pretax elective contributions and designated Roth contributions must set forth the amount of default contributions that will be designated Roth contributions and pretax contributions. If the default contributions are designated Roth contributions, then the employee who has not made an affirmative election is deemed to have irrevocably designated the contributions as Roth contributions.
The final regulations retain the rule that allows a highly compensated employee (HCE) with elective contributions for a year that include both pretax and Roth contributions to elect whether excess contributions are to be distributed from pretax or designated Roth accounts. The final regulations clarify, however, that plans are not required to provide this option.
Distribution, Taxation, and Other Issues – The final regulations provide little guidance regarding distribution and taxation of designated Roth assets. The regulations do retain the proposed rule that a distribution of excess contributions is not includible in gross income to the extent that it contains designated Roth assets. But any earnings allocable to a corrective distribution of designated Roth contributions are includible in gross income. The regulations also specify that there are other aspects of designated Roth contributions that must be reflected in plan terms, but the IRS does not identify specific items to include in a plan. The only example the IRS provides on this topic is that a plan is permitted to allow an employee to elect whether a distribution will be made from a designated Roth account or other accounts, but offers no further distribution guidance except that a plan document must set forth the extent to which it permits this election.
Because these regulations are final, they help move the industry further along toward effectively incorporating designated Roth contributions into the 401(k) plan mainstream. But these contribution regulations do not contain the crucial distribution and amendment guidance the industry really needs to fully implement the Roth 401(k) contribution feature. Watch BISYS’ web site for more information upon release of further IRS guidance.