PROPOSED REGULATIONS FOR ROTH 401(k) DISTRIBUTIONS

Prepared by: Debra L. Mackey, Esq.

Burr & Forman LLP

Birmingham, Alabama

In January, we posted an article on the final regulations for Roth 401(k) contributions. Shortly thereafter, the IRS issued proposed regulations on the taxation of distributions from Roth 401(k) accounts, the subject of this article. Any surprises in the new regulations? While the general rules are straight forward, the rollover rules are surprisingly complex.

General. The taxation of a Roth 401(k) distribution depends on whether the distribution is a “qualified distribution.” As stated in the previous article, a qualified Roth distribution is a distribution from a Roth account after five tax years that is made on or after age 59 1/2, death, or disability. A qualified distribution is not included in the participant’s gross income, i.e. the distribution is tax free for purposes of federal income taxes. The recent proposed regulations clarify that the five year period for determining qualified distribution status begins on the first day of the participant’s tax year (in most cases January 1) during which the participant first makes a Roth contribution to the plan, and ends after five consecutive tax years. For example, assume participant’s first Roth contribution to the plan is made on April 1, 2006. The five year period begins on January 1, 2006 and runs through 2010.

A nonqualified distribution is taxed under the separate contract rules of Code Section 72, allocating the distribution between the portion allocable to the participant’s investment in the contract (previously taxed) and the portion allocable to earnings, on a pro rata basis. Even if the distribution is nonqualified, only the portion attributed to earnings is included in income. The previously taxed contributions (investment in the contract) are not. For example, assume participant’s Roth account consists of $9,400 in designated Roth contributions and $600 in earnings. Participant receives a distribution of $5,000. Of this, $4,700 (9,400/10,000 x 5,000) is allocated to the participant’s designated Roth contributions (a tax free distribution) and $300 (600/10,000 x 5,000) is allocated to earnings (included in income).

The following types of distributions are not qualified distributions regardless of when distributed: corrective distributions of amounts that exceed the Code Section 415 limits; corrective distributions of contributions in excess of the Code Section 402(g) deferral limit; distributions necessary to pass the ADP or ACP test; a deemed distribution of a loan in default; the taxable portion of a life insurance premium; and certain Code Section 404(k) dividends (related to ESOPs).

Employer Securities. If employer securities are distributed in a qualified distribution, the basis in those securities is the fair market value on the distribution date. Therefore, none of the value is currently included in income and any gains on a future disposition of the securities will be taxed as a capital gain. If the distribution is not a qualified distribution, the same proration as described above applies.

402(g) Limit Correction. A distribution of a Roth contribution that exceeds the 402(g) limit is subject to the gap period income requirements just like a pre-tax deferral. If the distribution occurs by April 15th of the following year, the gap period income (but not the Roth contribution) is included income. However, if such a Roth contribution is not distributed by the April 15th of the following year, the entire distribution is included in income. This means that the Roth contribution is first taxed when the contribution is made and the Roth contribution is taxed again upon distribution. Furthermore, no part of the distribution is eligible for rollover.

Rollovers. As stated in the introduction, the proposed regulations provide a rather complex set of rules regarding rollovers. Listed below are the rules regarding rollovers from and to a Roth 401(k) plan, followed by the rules for determining the five year holding period where a rollover is involved.

Rollover of qualified Roth distributions:

· A qualified Roth distribution can be directly rolled into another Roth 401(k) plan that agrees to separately account for the rollover.

· A qualified Roth distribution can be directly rolled into a Roth IRA.

· A participant who receives a qualified Roth distribution may roll it into a Roth IRA within sixty (60) days. Note that the income limits on making a Roth IRA contribution do not apply for purposes of establishing a rollover Roth IRA.

· The entire amount of a qualified Roth distribution that is rolled to a Roth IRA is treated as basis in the Roth IRA.

Rollover of nonqualified Roth distributions:

· A nonqualified Roth distribution can be rolled into a Roth IRA.

· The investment in the contract in the Roth 401(k) is treated as basis in the Roth IRA.

Partial rollovers:

· Participant receives a distribution from a Roth 401(k) and rolls over a portion of that distribution into a Roth IRA. The portion not rolled over is treated as consisting first of the amount of the distribution that is included in income. In other words, the participant is not permitted to rollover the taxable portion of the distribution and retain the nontaxable portion. This situation arises when the distribution consists in part of a taxable amount (nonqualified) and in part of a nontaxable amount (qualified).

· Participant receives a distribution from a Roth 401(k), part of which is taxable (nonqualified) and part of which is not taxable (qualified). The participant may rollover the taxable portion into another Roth 401(k) within sixty (60) days. The nontaxable portion cannot be rolled into another Roth 401(k).

Rollovers not permitted:

· A qualified Roth distribution cannot be rolled into another Roth 401(k) plan except in a direct rollover.

· A qualified Roth distribution from a Roth 401(k) cannot be rolled into a Roth 403(b) plan.

· A Roth 401(k) cannot receive a rollover from a Roth IRA.

Determining five year period:

· The period of participation in the distributing Roth 401(k) does not carry over to the receiving Roth 401(k) for purposes of determining if the five year Roth holding period is met in the receiving plan.

· The period of participation in a distributing Roth 401(k) does not carry over to the receiving Roth IRA for purposes of determining if the five year Roth holding period is met in the Roth IRA.

· The five year periods for Roth 401(k) accounts and Roth IRAs are determined independently. If an employee participates in multiple Roth 401(k) plans, the period for each 401(k) plan is determined independently. However, the holding period in any Roth IRA counts toward the five year holding period in any other Roth IRA, including a rollover Roth IRA.

Administrative Responsibilities. The proposed regulations contain several reporting and recordkeeping responsibilities, with most of them falling on Roth 401(k) plan administrators. These responsibilities are listed below.

All plans

· The employer must report designated Roth contributions annually on Form W-2.

· The plan administrator must keep track of the five year period for each participant.

· The plan administrator must keep track of the amount of designated Roth contributions for each participant.

Distributing plan

· The plan administrator must report the amount of the investment in the contract and the first year of the five year period to the receiving plan in the event of a direct rollover; alternatively, the distributing plan may state that the distribution is a qualified Roth distribution. The information must be provided within 30 days of the rollover.

· For any distribution that is not a direct rollover to another Roth 401(k) plan, the plan administrator must, within a reasonable period, provide the participant (upon request) with the amount of the investment in the contract or state that the distribution is a qualified Roth distribution. In no event may the information be provided later than thirty (30) days after the request.

· The plan administrator must report distributions on Form 1099-R. The proposed regulations state that additional guidance on the 1099-R reporting will likely be issued.

Receiving plan

· The plan administrator must agree to separately account for the investment in the contract for any Roth rollover received.

· If a plan accepts a rollover of a taxable Roth distribution, the administrator of the receiving plan must notify the IRS that the plan accepted the rollover contribution along with the name, social security number and the amount of the rollover, the year the rollover was made, and any other information that the IRS may require.

Employee

· In a rollover from a Roth 401(k) to a Roth IRA, the individual employee should keep track of the amount rolled over in accordance with IRS Form 8606.

403(b) Plans.

The proposed regulations apply generally to 403(b) plans in the same way as they apply to 401(k) plans. One important distinction is the universal availability requirement for 403(b) plans. The proposed regulations apply the universal availability requirement to Roth contributions. Therefore, if any employee has the right to make a designated Roth contribution to a 403(b) plan, then all employees must have that right.

Effective Date.

These proposed regulations are generally effective for tax years beginning on or after January 1, 2007. In the interim, taxpayers may rely on the proposed regulations. Certain portions, however, apply for tax years beginning on or after January 1, 2006. These are: separate accounting requirements, rollover rules, coordination between Roth 401(k) and Roth IRA, and the excess 402(g) distribution rule. The proposed regulations will apply to 403(b) plans at the time that the current 403(b) proposed regulations become final.