Since the introduction of the Roth IRA in 1997, it has become a popular retirement vehicle. However, the contribution limits for the Roth IRA have been relatively low and, due to participant income limitations, not everyone has been able take advantage of the Roth designation. The Economic Growth and Tax Relief Reconciliation Act of 2001, P.L. 107-16 (EGTRRA), added Sec. 402A, which provides for designating Roth contributions. Effective January 1, 2006, many individuals previously excluded can now take advantage of the tax-free growth of Roth contributions by means of the Roth 401(k). The Roth 401(k) is not a new plan but a feature for designating deferrals as Roth contributions.
Amendments to the regulations under Secs. 401(k) and (m) provide guidance on designating Roth contributions under Sec. 402A. Initially, Sec. 402A was to sunset on December 31, 2010, but the Pension Protection Act of 2006, P.L. 109-280, made the changes under EGTRRA permanent. This item explains ten things taxpayers should be aware of when considering a Roth 401(k). (For an in-depth discussion of the Roth 401(k) rules, see Beausejour and Lynch, “An Analysis of the New Roth 401(k)/403(b) Plans,” 39 The Tax Adviser 515 (August 2008).)
1. Applicable PlansThe Roth 401(k) is a feature that can be added to a new or existing company-sponsored defined-contribution pension plan, including (1) a plan qualified under Sec. 401(a), which includes a traditional 401(k) and a safe-harbor 401(k); and (2) a 403(b) tax-sheltered annuity arrangement (Sec. 402A(e)(1)). The Roth feature is not allowed in a SARSEP or a SIMPLE IRA plan because they are not applicable retirement plans under Sec. 402A(e)(1). Employees elect to designate a portion or all of their elective contributions as Roth contributions (Sec. 402A(b)(1)).
2. Rules for RothContributions are included in gross income at the time the employee would have received the contribution amounts in cash if the employee had not made the cash or deferred election. Earnings on the account accumulate tax free and, if the distribution is qualified, the distribution is tax free. Therefore, as long as all distributions from an account are qualified distributions, the earnings on the Roth 401(k) funds are never taxed (per Sec. 402A(d)(1)).
3. Qualified and Early DistributionsA qualified distribution is one that occurs at least five years after the year of the participant’s first designated Roth contribution (counting such first year as part of the five) and is made on or after the participant reaches age 59½, because of the participant’s disability, or on or after the participant’s death (Sec. 402A(d)(2)). Sec. 402A does not provide a specific ordering rule regarding unqualified distributions from designated Roth accounts, so Sec. 72 applies to determine the character of distributions from such accounts (Regs. Sec. 1.402A-1, Q&A-3).
4. Funds Designated IrrevocablyRoth contributions are designated irrevocably, so once the designation is made, there is no reversing it (Regs. Sec. 1.401(k)-1(f)(1)(i)). However, the employee must have an opportunity to make or change future elections at least once during a plan year (Regs. Sec. 1.401(k)-1(e)(2)(ii)).
5. Plan Must Also Offer Pretax Elective ContributionsA plan cannot allow for only Roth contributions; it must also allow for the traditional, pretax elective deferrals (Regs. Sec. 1.401(k)-1(f)). This means that many forms used in the plan’s administration will need to be modified to accommodate both features.
6. Contribution ElectionsAn individual may make both traditional pretax and Roth designated contributions in a plan year. In 2008, an individual has an aggregate elective contribution limit of $15,500 for all designated Roth contributions and traditional pretax contributions, with an additional $5,000 if the participant is age 50 or over (Notice 2006-98). The maximum employee and employer annual contribution is the lesser of $46,000 or 100% of compensation. Under Sec. 402A(c)(2), if, for example, an individual chooses to designate $12,000 as Roth contributions, he or she may designate the remaining $3,500 (or $8,500, if over age 50) as traditional pretax contributions. Any additional contributions over the $15,500 (or $20,500) limit up to $46,000 will be treated as after-tax contributions (included in income), and the earnings will be tax deferred.
7. Matching Contributions Are Not RothEmployers may match Roth contributions, but these contributions may not be added to the Roth account (Regs. Sec. 1.401(k)-1(f)(2)). Rather, the employer match will be with pretax moneys and must be kept in a separate account. Whereas the employee Roth contributions may be withdrawn tax free, the employer-matched moneys, like any pre-tax contribution to a 401(k) account, will be treated as ordinary income at withdrawal.
8. Separate Accounting RequiredBecause the 401(k) plan will allow for pretax contributions that are includible in income when distributed (traditional and employer matched contributions) and contributions made with after-tax income that will be distributed tax free (Roth contributions), there must be separate accounts and separate recordkeeping for the different types of contributions (Sec. 402A(b)(2)). This was further clarified to apply to the treatment of separate accounts regarding automatic rollover rules for mandatory distributions (Sec. 402A(d)(4)). In addition, gains, losses, and other charges must be separately allocated on a reasonable and consistent basis to the designated Roth account.
9. Only Roth-to-Roth RolloversWhereas a traditional IRA may be converted to a Roth IRA, there is no provision for converting a pretax elective contribution account under a 401(k) to a designated Roth account. A direct rollover of a distribution from a Roth 401(k) may only be made to another Roth elective deferral account, such as another Roth 401(k) or a Roth IRA (Sec. 402A(c)(3)(A)). Regs. Sec. 1.408A-10, Q&A-2, clarified that a rollover from a Roth 401(k) to a Roth IRA may take place even if the individual is not eligible to make regular or conversion contributions to a Roth IRA due to income limitations
10. Set Up by Year EndThe Roth designation is a feature of a new or existing 401(k) plan. The plan does not have to be modified before accepting Roth designated moneys; however, the plan does need to be amended by the end of the plan year (December 31 for calendar year plans) for contributions made that year to be considered Roth designated. For example, funds may be designated Roth on July 1, 2008, even if the Roth feature has not been designated to the plan, as long as the plan is amended by December 31, 2008 (Notice 2005-95).
ConclusionThe most appropriate participants for the Roth designations are those that would like to contribute to a Roth IRA for tax-free growth but are unable to do so because of income limitations or those that would like to contribute more than they are currently allowed. In general, younger individuals saving for retirement and those who expect their tax bracket to increase would benefit greatly from making Roth designations. But the benefit will be realized only if the designation is used, and 401(k) participants and employers will certainly not adopt the designation if they are not familiar with it.
Frank J. O’Connell Jr. is a partner in Crowe Chizek in Oak Brook, IL.
Unless otherwise noted, contributors are members of or associated with Crowe Chizek.
For additional information about these items, contact Mr. O’Connell at (630) 574-1619 or firstname.lastname@example.org.