FINAL REGULATIONS FOR ROTH 401(k) CONTRIBUTIONS

 

Prepared By: Debra L. Mackey, Esq.

Burr & Forman LLP

Birmingham, Alabama

 

THEY'RE HERE!!! If you have been waiting for the Roth 401(k) regulations to be finalized before deciding whether to add the Roth feature to your 401(k) plan, then this article is for you.

At the end of 2005, the IRS issued final regulations governing designated Roth contributions to 401(k) plans. The regulations are effective January 1, 2006, and generally apply to plan years beginning on or after January 1, 2006. But what, exactly, is a “designated Roth contribution”? Under the regulations, a designated Roth contribution is: (1) an elective contribution made under a 401(k) plan that the employee irrevocably designates at the time of the election as a designated Roth contribution made in lieu of all or a portion of the pre-tax elective contributions the employee is eligible to make, (2) included in the employee’s gross income at the time the employee would have received the amount in cash but for the deferral election, and (3) maintained in a separate account. In other words, a designated Roth contribution is an after-tax deferral election that is accounted for separately from all other contributions to the plan. An employer who wishes to add the Roth 401(k) feature to its 401(k) plan must amend the plan by the end of the plan year in which the Roth feature is effective.

Roth contributions are generally subject to the same rules that apply to regular pre-tax 401(k) deferral contributions. They are treated as an employer contribution for most qualified plan purposes and as an elective contribution for purposes of the ADP test. Like pre-tax elective deferrals, designated Roth contributions are subject to the required minimum distribution rules, the election timing and default election rules, the 402(g) dollar limit on deferrals, and 401(k) nonforfeitability and distribution restrictions. The regulations clarify that the automatic enrollment (negative election) rules apply to Roth contributions as well, so long as the plan terms provide for it. Roth contributions may even be used for plan loans and to make a catch-up contribution. The regulations include a special rule for correcting ADP/ACP test failures where the employee made both Roth contributions and pre-tax deferral contributions. This special rule allows a 401(k) plan containing the Roth option to include language that will allow highly compensated employees to elect between receiving a distribution of pre-tax deferrals or designated Roth contributions as a corrective distribution for ACP or ADP test failures. The plan may also fix the correction method by its terms without providing the election. In the event a corrective distribution is made from the Roth account, the portion attributable to earnings is included in the employee’s income.

There is no gross income restriction on who may make a designated Roth contribution as there is for the Roth IRA. This is a positive feature of the Roth 401(k). Of course, the 401(k) plan must provide the Roth option, and the final regulations clarify that an employer may not establish a stand alone Roth 401(k) plan. This means that an employer may design its 401(k) plan to offer a pre-tax elective contribution only, or both the pre-tax elective contribution and the designated Roth contribution. The regulations make clear that some of the positive features of the Roth IRA, however, do not apply to the Roth 401(k). Notably: employees may not accumulate Roth 401(k) balances indefinitely because they are subject to distribution in accordance with the required minimum distribution rules; a regular 401(k) account cannot be converted into a Roth 401(k); and Roth 401(k) distributions that are not qualified Roth distributions (defined below) are taxed under Code Section 72. Proposed regulations on the taxation of such distributions will be issued shortly.

The regulations detail the separate accounting requirements imposed on Roth contributions. These contributions (and the earnings thereon) must be maintained in a separate Roth account from the time the first designated Roth contribution is made until the Roth account has been fully distributed. While Roth contributions may be matched, the matching contributions may not be made to the Roth account. This means that matching contributions and any forfeitures of them may not be allocated to the Roth account, and are therefore taxable upon distribution. In addition, the participant’s investment in the contract must be tracked. This is the amount of the Roth contributions (not counting earnings) minus any distributions (not counting earnings) of Roth contributions.

The regulations clarify that while direct rollovers from a designated Roth account are permitted, a rollover may be made only to another designated Roth account that is part of a 401(k) plan (or 403(b)) or to a Roth IRA. The 401(k) Plan may (but is not required to) apply the de minimis rule separately to the Roth 401(k) and regular 401(k) benefits. This means that if the Roth 401(k) benefit is less than $200, but the regular 401(k) is more than $200, the Plan would not have to permit a direct rollover of the Roth 401(k) benefits or apply the automatic rollover rule to the Roth 401(k) benefit.

The most attractive feature of the Roth 401(k) is that a qualified distribution of Roth contributions and the earnings thereon is excludable from the employee’s income. A qualified Roth distribution is a distribution from the Roth account after five tax years (beginning with the first tax year that a designated Roth contribution is made), that is made on or after age 59 1/2, death or disability. The final regulations do not alter these requirements.