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CCH® PENSION AND BENEFITS — 5/7/07

Final IRS rules provide guidance on distributions from Roth 401(k) arrangements

The IRS has issued final regulations under Code Sec. 402A that provide comprehensive guidance on the taxation of distributions from designated Roth accounts established under 401(k) and 403(b) plans. The final regulations generally apply to tax years beginning on or after January 1, 2007.

The regulations also provide guidance on reporting requirements with respect to Roth 401(k) and Roth 403(b) accounts and include amendments to the final 401(k) regulations relating to designated Roth contributions. The regulatory preamble notes that the proposed 402A rules, which were issued in January 2006, also would have amended the proposed 403(b) regulations. This guidance has not been finalized, but will instead be included in final 403(b) regulations. In addition, the final regulations amend the existing Roth IRA regulations in order to reflect the interaction between the Roth IRA rules of Code Sec. 408A and the designated Roth contribution rules of Code Sec. 402A.

Separate accounting requirement

A designated Roth account is a separate account under a 401(k) or 403(b) plan to which designated Roth contributions are made and for which separate accounting of contributions, gains, and losses is maintained. The final regulations retain the proposed rule that any transaction or accounting method involving an employee’s designated Roth account and any other accounts under the plan or plans of an employer that has the effect of directly or indirectly transferring value from another account into the Roth account violates the separate accounting requirement.

Determining the 5-tax-year period for qualified distributions

A “qualified distribution” from a designated Roth account is not includible in the employee’s gross income. A qualified distribution is one that is made after a 5-tax-year period of participation and is either made after the employee’s death, attributable to the employee’s disability, or made on or after the employee’s attainment of age 59 1/2. The 5-tax-year period begins on the first day of the employee’s tax year for which the employee first had designated the Roth contributions made to the plan and ends when five consecutive tax years have been completed. The final regulations provide that designated Roth contributions made by a reemployed veteran are treated as made in the tax year with respect to which the contributions relate.

The final regulations provide that certain contributions do not start the 5-tax-year period of participation. These would include (1) contributions made in a year in which the only contributions consist of excess deferrals, (2) excess contributions that are distributed to prevent an ADP failure, and (3) contributions returned to the employee under the special rules for certain withdrawals from eligible automatic contribution arrangements under Code Sec. 414(w).

Code Sec. 402A and Code Sec. 408A each contain different rules for determining when the 5-tax-year requirement is satisfied. Generally, under Code Sec. 402A, satisfaction of the 5-tax-year requirement with respect to a designated Roth account under a plan is based on the years since a designated Roth contribution was first made by the employee under that plan. In contrast, the 5-tax-year period under Code Sec. 408A begins with the first tax year for which a contribution is made to any Roth IRA. The final regulations make it clear that these 5-tax year periods are determined independently. Thus, in the case of a rollover of a distribution from a Roth 401(k) or Roth 403(b) plan to a Roth IRA, the period that the rolled-over funds were in the designated Roth account does not count toward the 5-tax-year period for determining qualified distributions from the Roth IRA.

Rollover of designated Roth contributions

As with the proposed rules, the final regulations provide that, in order to roll over any portion of the basis in a designated Roth account into a designated Roth account under another plan, the rollover must be accomplished by means of a direct rollover. Thus, a rollover to another designated Roth account is not available for the portion of the distribution not includible in gross income if the distribution is made directly to the employee. However, the requirement that the receiving plan separately account for designated Roth contributions that are rolled over has been eliminated because such contributions are independently subject to a separate account requirement contained in the final 401(k) regulations.

Reporting and recordkeeping

The plan administrator or other responsible party with respect to a plan with a designated Roth account is responsible for keeping track of the 5 tax-year period for each employee and the amount of designated Roth contributions made on behalf of such employee. In addition, the plan administrator of a plan directly rolling over a distribution is required to provide the administrator of the recipient plan with a statement indicating either: (1) the first year of the 5-tax-year period for the employee and the portion of such distribution attributable to basis or (2) that the distribution is a qualified distribution. If the distribution is not a direct rollover to a designated Roth account under another eligible plan, the plan administrator or responsible party must provide to the employee, upon request, this same information, except the statement need not indicate the first year of the 5-tax-year period.

To the extent that a portion of the distribution is includible in income (determined without regard to the rollover), if any portion of that distribution is rolled over to a designated Roth account by the distributee rather than by direct rollover, the plan administrator of the recipient plan must notify the IRS of its acceptance of the rollover contribution. The final regulations clarify that this reporting is only required to the extent provided in IRS forms and instructions.

For more information on this and related topics, consult the CCH Pension Plan Guide.

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