New guidance on Roth distributions

Now that the provisions allowing employees to make designated Roth elective deferrals to 403(b) and 401(k) plans are permanent, more employers are considering adding this feature to their plans. If your plan offers Roth elective deferrals or you are thinking about offering them, you’ll want to be familiar with the recently issued final regulations on distributions from Roth 403(b) and 401(k) accounts. Following are some key points made in the regulations.

How are Roth 403(b) or 401(k) account distributions taxed? The tax treatment depends on whether the distribution is “qualified.” With a qualified distribution, the employee does not include any amount in income for federal tax purposes. Generally, a distribution is qualified if it is made (1) after the employee reaches age 59½ or on account of disability or death, and (2) after a 5-year period has elapsed. If a distribution is not qualified, the portion of the distribution allocable to account earnings is subject to income tax and possibly to a 10% early withdrawal penalty.

Do the regulations address how the 5-year period is determined? As with the proposed regulations issued in early 2006, the final regulations say the 5-year period begins on the first day of the employee’s tax year in which the employee first makes a designated Roth contribution to the employer’s plan and ends when five consecutive tax years have passed. A contribution that is returned as an excess deferral, excess contribution, or “permissible withdrawal” from an automatic contribution arrangement (after 2007) does not begin the 5-year period.

What about rollovers? Employees may make tax-free rollovers of eligible rollover distributions from a designated Roth account to either a designated Roth account with another employer’s plan or to a Roth IRA. The final regulations expand the rules so that a Roth 403(b) can be rolled over to a Roth 401(k) and vice versa. However, rollovers of designated Roth elective deferrals (i.e., the nontaxable amount) to another designated Roth account must be accomplished through a direct rollover. If an eligible rollover distribution is instead paid to the employee, the employee could still roll over the entire amount (or any portion of it) to a Roth IRA within 60 days.

If a nonqualified distribution is paid to the employee and less than the entire amount is rolled over, the part that is rolled over is deemed to consist first of the portion of the distribution attributable to account earnings. It is possible for an employee to roll over the taxable (i.e., earnings) portion of a distribution from a designated Roth account into a designated Roth account under another plan within 60 days. However, the recipient plan would have additional reporting requirements.

Is the employee’s 5-year period of participation carried over to the account receiving the rollover?

It depends.

• For direct rollovers to another employer’s plan, the starting date of the 5-year period generally carries over to the new plan account if the starting date is earlier than that of the new plan.
• For direct rollovers made to an alternate payee’s or spouse beneficiary’s designated Roth account, the employee’s starting date carries over unless the receiving account had an earlier starting date.
• For indirect rollovers of taxable amounts to a designated Roth account under another plan, the employee’s period of participation under the distributing plan generally does not carry over. The taxable year the rollover is completed begins a new 5-year period for a participant who has made no prior designated Roth elective deferrals to that plan.
• For rollovers to Roth IRAs, the starting date depends on whether the employee has an existing Roth IRA. If the employee does not, the 5-year period begins with the year the rollover is completed. If the employee already has a Roth IRA, the 5-year period for the amounts attributable to the rollover contribution is the same as the period for the previously established Roth IRA.

When do the new regulations take effect? They are effective April 30, 2007, and generally apply to tax years beginning on or after January 1, 2007.

Source: NPI © (Summer 2007)

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