On March 1, the IRS released the much awaited proposed Roth 401(k) regulations.
Discussed herein are the proposed rules and some areas that require change or clarification when the final rules are released. The IRS provided a 90-day period for interested parties to submit written comments about the proposed rules and recommend ways to improve them.
Roth contributions are after-tax elective deferral contributions to a 401(k) or 403(b) plan that, unlike pre-tax elective deferrals, are includable in gross income. At qualified distribution the Roth contributions, including earnings, are tax-free and excluded from gross income.
Contributions and limits
The Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) authorized the establishment of Roth 401(k) accounts beginning Jan. 1, 2006.
The proposed rules provide that if a plan offers these accounts, participants may irrevocably designate that some or all their elective deferral contributions be treated as Roth contributions.
Unlike "traditional" deferral contributions, which are not subject to federal income tax when they are contributed to the plan, Roth contributions will be included in the employee's current taxable income, but generally will not be taxable when they are later distributed from the plan.
Under the current proposal, participants only may designate future contributions to be Roth contributions. In contrast to a taxpayer's ability to convert traditional IRAs to Roth IRAs, participants may not designate previously contributed deferral contributions as Roth contributions.
While Roth 401(k) contributions will be treated as post-tax contributions for income tax purposes, they will be treated as pre-tax contributions for purposes of the maximum deferral limit.
For example, for 2006, the first year in which Roth 401(k) contributions may be made, a participant's combined pre-tax and Roth 401(k) contributions cannot exceed $15,000.
Roth 401(k) contributions also will have to be included in the Actual Deferral Percentage (ADP) Test and will be subject to the minimum required distribution (MRD) rules.
"Qualified" distributions of Roth 401(k) contributions and related earnings will not be subject to federal income tax.
According to the proposed rules, a distribution is "qualified" if it is made after the participant reaches age 591/2, or on account of the participant's death or disability, and is made at least five years after the date the first Roth 401(k) contribution was made.
This five-year requirement appears to apply even if the distribution is made on account of a participant's retirement.
Plan administration and record-keeping issues
The proposed regulations require plans to record Roth 401(k) contributions and related earnings in a separate account (or money source).
Amounts in Roth 401(k) accounts may be rolled over to a Roth IRA or to another 401(k) plan or 403(b) program that accepts Roth contributions. It is not clear if rolled-over Roth accounts must be separately accounted for or can be combined with new Roth contributions.
Under the proposed rules, plans may permit highly compensated employees who make both Roth and traditional pre-tax 401(k) contributions to elect whether to take ADP Test corrective distributions from their pre-tax or Roth contributions.
While this rule provides flexibility to participants, many believe that such individual elections will create additional record-keeping burdens that will greatly outweigh its benefits. As a result, the IRS will be urged to provide a more administratively efficient, uniform rule when the regulations are finalized. Issues requiring additional guidance
The proposed regulations do not provide specific guidance on many of the issues involving the taxation of distributions of Roth contributions. For example, the proposed rules do not address the ordering rules for the recovery of an employee's "investment in the contract" (or post-tax contribution amount).
The IRS specifically has asked for comments on these issues and on other issues for which guidance is needed.
After reviewing these proposed rules we have identified a need for additional guidance regarding the taxability, including the applicability of the 10 percent excise tax on premature distributions, of
• non-"qualified" distributions,
• defaulted plan loans that include Roth contributions and
• hardship withdrawals.
In addition, we expect to comment on the inconsistency of subjecting Roth 401(k) accounts to the MRD rules when these contributions may be rolled over to a Roth IRA where the MRD rules do not apply.
We will also seek guidance on
* the operation of the five-year rule, especially when Roth accounts are rolled over;
* the treatment of automatic rollovers for Roth contributions; and
* the permissibility of converting existing post-tax contributions to Roth 401(k) contributions.
Finally, the proposed rules provide guidance only on Roth 401(k) accounts. They do not cover Roth 403(b) arrangements. We expect the IRS to issue guidance on Roth 403(b) arrangements when the final Section 403(b) regulations are published later this year.
We anticipate that the rules relating to Roth 403(b) accounts will closely resemble the rules that apply to Roth 401(k) accounts.
Peartree is the director of Barney & Barney's retirement services division. For more information, call (858) 550-4978 or e-mail BillP@barneyandbarney.com.>