How Does the IRS Describe an After-tax Elective Deferral? Which Plans are Affected?

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1 Roth 401k Regulations In January, 2006 the IRS finalized regulations addressing designated Roth-style 401k and 403b accounts and they proposed regulations addressing rollovers and the taxation of distributions. Remaining uncertainties are how premature distribution penalties will be applied and whether it is possible to avoid required minimum distributions by rolling a designated Roth account over to a Roth IRA. Although designated Roth accounts bear some similarity to a Roth IRA (e.g., contributions are after-tax and qualified distributions are tax-free), there are many differences. For example, nonqualified distributions from Roth IRAs are generally a nontaxable return of basis while nonqualified distributions from designated Roth accounts are generally a pro rata distribution of nontaxable basis and taxable earnings. In addition, the 5-year qualification period for a Roth IRA begins with the first contribution to any Roth IRA whereas the 5-year qualification period for a designated Roth account begins with the first contribution to that specific account. Employees who can afford to contribute without a current income tax benefit will generally gain from Roth-style deferrals while those who need the income tax benefit currently should generally continue to contribute on a pre-tax basis. See the EA Journal, January/February 2006 or the AAII Journal, December 2005 for details. For the regulations, see and The following commentary is a preliminary draft addressing the topics that affect my practice. Please advise peter@lingane.com of errors and of confusion. Thank you. Return to Home Page How Does the IRS Describe an After-tax Elective Deferral? The January 2006 regulations address designated Roth contributions to a designated Roth account inside a 401(k) or 403(b) plan. In effect, the employee has two accounts, one for before-tax contributions and one for after-tax contributions. Investment allocations could be the same in both accounts, or different. What is key is the ability of the plan administrator to track the earnings attributable to the after-tax contributions. Which Plans are Affected? After-tax elective deferrals are allowed to 401(a) plans, which usually means a 401(k) plan, and to 403(b) plans Peter James Lingane All rights reserved. 1

2 (tax-sheltered annuities) 1. Although elective deferrals are allowed to SIMPLE and SARSEP plans and to 457 deferred compensation arrangements, after-tax deferrals are not permitted to these plans. The tax code distinguishes between elective deferrals, whereby each employee decides how much of his or her compensation to contribute to the plan, and contributions such as a match over which the employee has no control. Employees can choose the tax treatment for elective deferrals only; other contributions are before tax. The employer must amend the plan before employees can make after-tax contributions. How Much Can be Designated as a Roth Contribution? An employee is allowed the same contribution limit on either a before-tax or after-tax basis. If the specific plan permits an elective deferral of $10,000, the employee may elect to contribute $10,000 pre-tax or after-tax, or $5,000 pre-tax and $5,000 after-tax, or any other combination. The employer has considerable latitude in setting contribution limits. However, the maximum deferral, known as the 402(g) limit, is $15,000 (in 2006). Catch-up contributions for those fifty and older, any employer match of elective deferrals and rollover contributions are not considered when determining the deferral. When an employee participates in more than one deferral plan, the limit applies to the aggregate of all deferrals. That is, an employee s deferrals to a Roth-style 401(k) plan or plans plus pre-tax deferrals to a pre-tax 401(k) plan or plans plus Roth-style and pre-tax deferrals to 403(b) plans plus pre-tax deferrals to SIMPLE and SARSEP plans cannot exceed $15,000 in In addition, the total contribution (elective deferral plus match plus other employer contribution) to a defined contribution plan cannot exceed the 415 limits of $44,000 (in 2006) or 100% of compensation. When an employee participates in more than one plan with the same employer, the 415 limits apply to the aggregate of all plans. When an employee participates in the plans of more than one employer, the 415 limits apply separately to each employer. Even with multiple employers, the taxpayer s aggregated elective deferrals cannot exceed the 402(g) limit. How Are Distributions Taxed? Qualified distributions are tax-free. 1 IRC 402A. The Internal Revenue Code and regulations do not address the federal Thrift Savings Plan. I suspect that after-tax deferrals would be permitted because court decisions treat this plan as if it were a 401(a) qualified plan. Peter James Lingane All rights reserved. 2

3 Part of each nonqualified distribution from a designated Roth account is a tax-free return of investment and part is taxable earnings. The allocation is generally determined under 72(e)(8). That is, the tax-free amount is determined by applying to the distribution amount the ratio of the investment in the contract to the account balance 2. If the account has been annuitized, converted to a series of payments for life, the tax-free portion of each distribution is generally determined by multiplying the distribution amount by an exclusion ratio; 72(b). The exclusion ratio is the investment in the contract as of the annuity starting date divided by the anticipated total distribution under the contract. In some situations, the anticipated total distribution is the product of a life expectancy and the payment amount. In other situations, the services of an actuary may be required to determine the exclusion ratio. This method is known as the general rule. Presumably the exclusion ratio method would not apply to qualified annuity distributions after the age and 5-year criteria were met. The proposed regulations do not address this issue. The regulations address a variety of special circumstances, including the distribution of employer securities. What is a Qualified Distribution? A distribution from a designated Roth account is a qualified distribution if the participant is aged 59½ (or disabled or if the distribution is after the death of the participant) and if the a designated Roth contribution was made to the account at least five years previously. The IRS has a special way of determining five years in this context. It is not five times 365 days. Rather, both the year in which the first after-tax contribution is made and the year in which the distribution is taken count as full years. A designated Roth contribution for 2006 and a distribution in 2010 meet the 5-year qualification standard 3. This definition is analogous to the 5-year period for qualified distributions from Roth IRAs. But note that a contribution to any Roth IRA starts the 5-year qualification period for all Roth IRAs whereas a designated Roth contribution starts the 5-year period for that plan only. 2 The proposed regulations do not include an example so it is unclear exactly how the IRS will implement this rule. I would hope that the IRS will develop procedures closely analogous to the taxation of IRAs (Form 8606). 3 This is true even though the income may have actually been deferred in December 2006 and the distribution may actually have been received in January 2010, a difference of only thirty-eight months. A self-employed individual could make a 2006 contribution as late as October 2007 and satisfy the five year rule with a distribution in January 2010, only twenty-seven months later! Peter James Lingane All rights reserved. 3

4 The distribution of an excess contribution is not treated as a qualified distribution. (See subsequent discussion.) How do Rollovers Affect the 5-Year Qualification Period? Normally, the qualification period for a designated Roth account is measured from the year of the initial contribution to the plan from which the distribution is taken. However, if the distribution can be traced to the direct rollover from another designated Roth account, and if the first contribution to the other plan was in an earlier year, the 5-year qualification period begins in the year of the earlier contribution. Roth IRAs have a different 5-year qualification period. The interval for all of a taxpayer s Roth IRAs is measured from the first contribution to any of the taxpayer s Roth IRAs. Query. Is this true even if the first Roth IRA is subsequently exhausted? Rolling a designated Roth account over to a Roth IRA does not affect the 5-year qualification period for subsequent distributions from the Roth IRA. Special Treatment of Certain Distributions. There is no requirement to take money from a designated Roth account if it is subsequently determined that too much has been deferred. There is no excise tax on excess deferrals as there is with excess contributions to an IRA. However, there is an incentive to correct excess deferrals in a timely manner 4 because the excess deferral is otherwise taxable income, with no adjustment for the investment in the contract. In addition, the distribution cannot be rolled over to another account. Any distribution from an account with an excess deferral is treated as a corrective distribution to the extent of the excess deferral (and earnings). This same rule applies to the treatment of pre-tax contributions which exceed the 402(g) limit and which are not withdrawn in a timely manner. The excess is not deductible in the year of contribution (independent of what is shown in Box 1 of the Forms W-2!) and is taxable income when distributed. Employer securities distributed from a designated Roth account receive capital gains treatment for post distribution appreciation, as is true for other distributions from a qualified plan. Failure to repay a loan is a deemed distribution. Such distributions are not qualified distributions. (What is to keep an employee from taking a 4 402(g)(2). The taxpayer must allocate the excess deferral among the plans by March 1 and the plans must distribute their allocated amounts, and the earnings thereon, by April 15 th. The earnings are taxable income in the contribution year. The excess deferral is not taxable income. Peter James Lingane All rights reserved. 4

5 distribution that would be a qualified distribution and using the proceeds to payoff the loan amount?) Other special cases are discussed in the proposed regulations. How Does a Rollover from Designated Roth Account Modify the Taxation of the Recipient Roth IRA? The distribution from a Roth IRA is ordered as follows. First, tax and penalty-free distribution of contributions. Second, tax-free distribution of conversion contributions. Premature distribution penalties may apply to the tax-free amount. Lastly, taxable distribution of earnings. Premature distribution penalties may apply. A qualified distribution from a designated Roth account that is rolled over to a Roth IRA is treated an a contribution to the Roth IRA. Consequently, a subsequent nonqualified distribution from the Roth IRA, of no more than the rollover amount, is not taxable income and premature distribution penalties never apply. Presumably, the rollover of a nonqualified distribution is considered a contribution to the extent that the rollover includes investment. The balance of the rollover is considered earnings. The 5-year qualification period for distributions from the Roth IRA is not influenced by the date of the first contribution to the designated Roth account being rolled over. Example. The taxpayer establishes a Roth IRA in In 2007, a nonqualified distribution is rolled from a designated Roth account to a Roth IRA. All subsequent distributions from the Roth IRA are tax and penalty free if the taxpayer is age 59½ (or death, disability) because the 5-year qualification period began in Example. The taxpayer had never established a Roth IRA prior to the rollover. The 5-year qualification period therefore begins with the rollover in Any distribution from the Roth IRA prior to January 2012 would be taxable income to the extent that the distribution exceeds the taxpayer s investment in the rolled over account. The regulations do not address premature distribution penalties. I expect that premature distribution penalties would apply on the taxable income unless the taxpayer was aged 59½ (or death, disability). Example. The first contribution to the designated Roth account was in 2006 and a qualified distribution from this account was rolled over to a Roth IRA in The taxpayer had never established a Roth IRA previously. Peter James Lingane All rights reserved. 5

6 Any distribution from the Roth IRA prior to January 2014 is a nonqualified distribution because the 5-year qualification period is measured from the year in which the taxpayer establishes their first Roth IRA. Distribution of the rollover amount from the Roth IRA would be tax-free because of the ordering rules but any distribution in excess of the rollover amount would be taxable income. No penalties would apply because the taxpayer is aged 59½ or another exception applies; we know this because the roller from the designated Roth account was a qualified distribution. What Restrictions Apply to Rollovers? Twenty-five years ago, it was relatively common for a defined contribution plan to accept after-tax contributions; the tax on earnings was deferred until the account was distributed. 402(c) allows only the before-tax portion from such accounts to be rolled over a traditional IRA (the employee receives a check for the after-tax portion in the event of a rollover) and only allows the after-tax portion to be rolled over to a defined contribution if the transfer is a direct trustee-to-trustee transfer and if the receiving plan agrees to account separately for the before-tax and after-tax elements. None of the rolled over amount is included in income. Similarly, any rollover from a designated Roth account to another 401(k) or 403(b) plan must be accomplished by a direct trustee-to-trustee transfer. Because of the need for separate accounting, a designated Roth 401(k) account cannot be rolled over to a designated Roth 403(b) account, or visa versa. Why?? The distributing plan must advise the recipient plan whether the distribution is a qualified distribution and, if it is not, the distributing plan must advise the recipient plan of both the amount which is attributed to investment and the year of the first contribution. An employee may roll the taxable portion of a nonqualified distribution from a designated Roth account to a designated Roth account in another plan under the 60-day rule. The nontaxable portion may not be rolled over to another plan under the 60-day a rule. The year of initial contribution is not carried over to the recipient plan for purposes of the 5-year qualification period. If an employee rolls over only taxable portion of a nonqualified distribution to another designated Roth account under the 60-day rule, the recipient plan must provide the IRS information so that they can determine whether the rollover was a valid contribution. (Effective for tax years beginning on or after January 1, 2007.) Peter James Lingane All rights reserved. 6

7 A designated Roth account can be rolled over to a Roth IRA, in whole or in part, via either a direct transfer or under the 60-day rule. If a nonqualified distribution to the employee exceeds the amount rolled over under the 60-day rule, the amount not rolled over is nontaxable to the extent that the amount not rolled over does not exceed the amount of the distribution allocated to investment. That is, the taxable portion is deemed to be rolled over first. Example. The employee takes a $14,000 nonqualified distribution from a designated Roth account. The distribution consists of $11,000 nontaxable return of investment and $3,000 of earnings. Within sixty days, the employee rolls over $7,000 to a Roth IRA; $7,000 is not rolled over. Because the amount not rolled over does not exceed the nontaxable portion of the distribution, none of the distribution is taxable income. The rolled over portion is deemed to include $3,000 of earnings and $4,000 of investment in the contract. The taxpayer is responsible for tracking information about rollovers to a Roth IRA. It can be necessary to track earnings in a rollover account even if the distribution is qualified. See example of a participant who is disabled at the time of the rollover but who subsequently recovers. Aggregation of Accounts. The proposed regulations consistently treat the designated Roth account as a single contract. If the employer maintains one account for designated Roth contributions and a second account for a rollover from a designated Roth account, these are treated as a single account when determining the taxation of nonqualified distributions. That is, a distribution from either account is taxed as if it were a pro rata distribution of basis and earnings from both accounts. If separate accounts are established pursuant to a qualified domestic relations order or are established for separate beneficiaries following the death of the employee, each account is treated as a separate contract. The taxable income upon an unqualified distribution from one account is unrelated to the investment and earnings in any other account. Can Designated Roth Contributions Be Recharacterized at a Later Date? The election to make a designated Roth contribution is irrevocable. Designated Roth contributions cannot be changed to pre-tax contributions at a later date. How Do Designated Roth Contributions Affect Discrimination Testing? Designated Roth contributions are treated as pre-tax elective contributions for the purposes of discrimination testing. Peter James Lingane All rights reserved. 7

8 Similarly, designated Roth contributions may be considered as catchup contributions under 414(v) and may serve as the basis for a participant loan. May an Employer Offer Only Roth-Style Elective Deferrals? No. The employee must elect a designated Roth contribution. Therefore, the employer plan must include the option to make before-tax deferrals. Are Minimum Distributions Required From a Designated Roth Account? Yes. It may be possible to finesse required distributions before death by rolling the account over to a Roth IRA but this possibility has not yet been addressed in regulations. Return to Home Page Peter James Lingane All rights reserved. 8