Employers should ensure their trustees and third-party administrators comply with the final Roth 401(k) distribution, rollover and taxation rules.

The Internal Revenue Service (IRS) recently released final regulations for designated Roth Accounts under section 402A of the Internal Revenue Code (the Code). The final regulations follow the proposed regulations released on January 26, 2006, with a few exceptions described below. This latest release of guidance regarding Roth 401(k) contributions did not reduce the amount of administrative obligations that can be placed upon plan administrators. If your 401(k) plan has already implemented Roth contribution provisions, you should discuss with your trustee and third-party administrator whether the proper distribution, rollover and taxation rules are in compliance with the applicable regulations.

Effective Dates

Section 402A of the Code, "Optional Treatment of Elective Deferrals as Roth Contributions," is generally effective for taxable years beginning on or after January 1, 2006. The final regulations are effective for taxable years beginning on or after January 1, 2007, with a few exceptions. The provisions regarding rollovers to designated Roth accounts and Roth individual retirement accounts (IRA), along with provisions under section 402(g) of the Code, are effective for taxable years beginning on or after January 1, 2006.

Section 403(b) Qualified Plans

The proposed regulations released on January 26, 2006, provided guidance with respect to Roth contributions under a section 403(b) qualified plan. The IRS decided not to finalize the provisions regarding 403(b) plans in these final regulations. Instead, regulations regarding Roth contributions to 403(b) plans will be finalized when the final regulations under section 403(b) are released.

Regulations under Section 402(g) of the Code

Section 402(g) of the Code provides the maximum amount a participant in a qualified plan may elect to defer each taxable year. For taxable years beginning in 2007, a plan participant may elect to defer $15,500. This maximum amount includes both pre-tax elective deferrals and Roth contribution deferrals. If designated Roth contributions are deemed excess deferrals (exceed the section 402(g) limit for the taxable year), the amount in excess may be returned to the plan participant without adverse tax consequences by April 15 of the year following the taxable year the excess occurred. The final regulations make it clear, however, that if such excess deferrals are returned to the plan participant after April 15, the amount of the excess (including income) is included in the gross income of the plan participant, despite the excess amount already being taxed at the time of initial deferral to the plan.

Interestingly, the final 402A regulations require that "gap-period income" must be calculated when making refunds to participants of deferrals in excess of the annual dollar limit under 402(g), regardless of whether the excess consists of Roth contributions or regular pre-tax 401(k) contributions. Gap-period income is the earnings on excess deferrals in participants’ accounts that accrue from the end of the year the excess deferral was made until the date of distribution. The requirement to calculate gap-period income on refunds or forfeitures to correct other types of excess contributions (such as Roth or regular 401(k) deferrals that exceed the average deferral percentage, or ADP, test in a given year, and matching contributions that exceed the annual contribution percentage, or ACP, test), is being eliminated in 2008 by the Pension Protection Act of 2006.

However, the final 402A regulations require the calculation of gap-period income for all excess deferrals, even after 2008. As a result, plan administrators faced with returning excess deferrals will need to calculate gap-period income on those refunds but will not be required to calculate gap-period earnings on contributions that simply exceed the ADP or ACP tests in plan years beginning after 2007 (unless required by the plan itself). Plan administrators will need to be aware of this differing treatment for these very similar types of plan corrections.

Qualified Roth Distribution

The determination of whether a distribution of Roth contributions is taxable is dependent on if the distribution is qualified. A qualified Roth distribution, which is not subject to federal income tax, is a distribution made after a participant reaches age 59 1/2, dies or becomes disabled, and in all events after the participant has satisfied a five-year participation requirement.

Five-Year Participation Requirement

As described in our article regarding Roth distributions (Roth 401(k)—IRS Issues Guidance on Distributions, Rollover and Plan Amendments), the five-year participation period begins on the first day of the calendar year in which the participant first made Roth 401(k) contributions and ends upon the completion of five consecutive calendar years. The five-year participation period is a one-time requirement, not a rolling requirement that applies separately to each year’s Roth 401(k) contributions. The final regulations clarified the use of the five-year participation requirement with respect to several types of distributions. For example, the determination of whether a specific payment satisfies the five-year participation requirement is based upon the actual year of the payment. Thus, if the payment is one of a series of payments, payments in that series that are made after the date the five-year participation requirement is satisfied will be tax-free (assuming the other qualified Roth distribution rules are satisfied).

Also, the regulations clarified that a re-employed veteran may contribute funds to a Roth contribution account and designate the year in which such contribution would have occurred if not for the veteran’s qualified military service. The five-year participation period commences during the year in which the Roth contribution was designated by the re-employed veteran (in accordance with provisions under the Uniformed Services Employment and Re-employment Rights Act, USERRA). If the veteran does not designate the year, the final regulations provide that the Roth contributions will be treated as having been contributed in the first year of the military leave (or, if later, the first year that Roth contributions could be made to the plan).

The regulations clarified that an age-70-1/2 required minimum distribution consisting of Roth contributions from a plan would be treated as made in the year the distribution actually occurs, even if the distribution is made with respect to a prior year. For example, many plans make the first required minimum distribution payment (after a participant attains age 70 1/2) on April 1 of the subsequent year, and the Code allows that payment to be treated as made in the prior year. Under the final 402A regulations, that payment would be treated as made in the year actually paid, rather than the prior year, which makes it more likely that the payment will satisfy the five-year participation requirement. Finally, the final regulations clarify that hardship withdrawals, age-70-1/2 required minimum distributions and payments in a stream of periodic payments all may be qualified distributions even though they are not eligible for rollover.

Automatic Rollover to IRA

Comments under the proposed regulations from employee benefits practitioners asked that the Roth contribution account and other accounts under a qualified plan be treated separately for purposes of applying the automatic rollover rules. The IRS responded to these comments in the final regulations by providing for the separate treatment of Roth contribution accounts and other accounts. For example, if a participant’s Roth contribution account has less than $1,000 and the participant has less than $1,000 in other accounts, the plan does not have to provide the participant with an automatic rollover for either the Roth contribution account or the other accounts, even though the combined value of the Roth and non-Roth accounts is greater than $1,000.

Rollovers of Roth Contribution Accounts

Under the proposed regulations, plans that accept rollovers of Roth contribution accounts were required to account for the rollovers separately from other Roth contributions to the plan. This required the plan to separately account for the Roth rollover amount and any future Roth contributions. The final regulations eliminate this requirement. Now, the plan accepting the Roth rollover funds may account for such funds in the regular Roth contribution account.

Also, plan administrators are required to notify the IRS if they accept rollovers of designated Roth contributions from participants rather than in a direct rollover from another employer’s plan. Administrators must report the employee’s name and social security number, the amount rolled over, the year in which the rollover contribution was made and any other information the IRS deems relevant to determine that the amount is a valid rollover contribution. However, the final regulations clarify that the IRS will issue special forms and instructions for this purpose. Administrators are not required to notify the IRS until these forms are issued.