Summary of Proposed Roth 401(k) & Roth 403(b) Distribution Regulations

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1 Summary of Proposed Roth 401(k) & Roth 403(b) Distribution Regulations As promised, we have reviewed the proposed Roth 401(k) and Roth 403(b) (hereinafter "Roth k/b") regulations. Throughout this summary we have provided references to the proposed distribution regulations. We apologize if these references and citations make this more difficult to read, but we needed to provide them so that it would be easier to reference the applicable spot in the proposed distribution regulations. While we will refer to these distribution regulations as Roth k/b, because only 401(k) and 403(b) plans may permit after-tax designated Roth contributions, the recently finalized regulations and these proposed distribution regulations actually are under Code sections 401(k), 403(b), 402(g) (annual deferral limit), 402A (designated Roth contribution rules), and 408A (Roth IRA rules). In addition, there are a large number of changes made in the regulations that do not directly deal with Roth k/b accounts that those involved with TPA services will have to closely review and understand so that a plan can be properly administered. It appears that the proposed distribution regulations are being used as an opportunity to revise provisions not directly related to designated Roth k/b accounts that the government believes have become outdated. The Roth k/b distribution regulations, like all IRS regulations, are published with a preamble that often provides a good explanation of the government's thinking with respect to the discrete provisions in the actual regulations. At page three of the of the proposed regulations, you will find a segment entitled "Background" and on page four a segment entitled "Explanation of Provisions." We recommend that those wishing to understand the specifics of Roth k/b accounts read the preamble, pages three through 10 The significant issues covered in these new Roth k/b distribution regulations are as follows: 1. Non Qualified Roth k/b Distribution. The preamble on page three confirms what we have been hearing that the government was not persuaded to allow distributions from Roth k/b accounts to be treated the same as distributions from Roth IRAs. While qualified distributions from each will be non taxable, distributions that are not qualified, e.g., not been in a Roth k/b account for five years, will have to be proportionately allocated between already taxed contributions and untaxed earnings. Such a distribution from a Roth IRA would come first from already taxed contributions and then from untaxed earnings. The purpose of these most recently proposed distribution regulations is to provide comprehensive rules concerning the taxation and reporting of distributions from Roth k/b accounts. A distinction is made in these proposed regulations with respect to calculating the taxable portion of a non qualified Roth k/b distributions made before vs. on or after the "annuity starting date." In general, for a Roth k/b account, the annuity starting date is the date all requirements have been met to get a distribution from that account, e.g., age 59 1/2 and severance of employment. While this distinction is made, it's not clear to us that there is any

2 difference in the calculation of the taxable portion of the non qualified Roth k/b distribution. See 1.402A-1, Q&A-3. That proportionate non taxable and taxable treatment is not the result for a non qualified Roth k/b distribution where only part of the distribution is rolled over. In that case, the part rolled over is deemed first to include income and then designated Roth k/b contributions. See 1.402A-1, Q&A-5(b). Corrective distributions, and earnings, due to failure of annual deferral maximum, ADP (only 401(k) plans) and ACP tests are not qualified distributions. See 1.402A-1, Q&A-2. Hardship distributions. Generally, hardship distributions may not include earnings on elective deferrals. Roth k/b contributions are elective deferrals and, therefore, for hardship purposes a distribution is limited to the Roth k/b contribution amount. However, because of the requirement that non qualified Roth k/b distributions must be a prorata amount between after-tax contribution and taxable earnings, such a hardship distribution from a Roth k/b account even though limited by rule to the after-tax contribution will still have a portion of it that has to be reported as taxable. See 1.402A- 1, Q&A Separate Accounting Requirement. Preamble on page four explains that the separate accounting requirement for Roth k/b accounts is violated if a transaction or accounting method "has the effect of directly or indirectly transferring value from another account into the designated Roth account..." For our annuity business, there is a concern that the enhanced death benefits such as a return of premium feature may violate the separate accounting requirement. In brief, the concern is that since the return of premium feature, for example, is applied to the entire contract the value of either (i) the designated Roth k/b account or (ii) the remainder of the plan account may be affected by the other. If the interaction between those two pieces of a single annuity contract would cause "value" to be shifted to the Roth k/b account, which in general is treated as a separate contract under these proposed distribution regulations, then there would be a violation of the separate accounting requirement. While still not perfectly clear to us, we do not recommend changing our current practice of using a single annuity contract and to allocate the return of premium feature between the Roth k/b account and the remainder of the contract based on the values of those two pieces at the time of distribution of the guarantee of premium payment. This provision is effective beginning 1/1/2006. See 1.402A-1, Q&A Rollover Only to Like Roth 401(k) Plan & Rollover Only to Like Roth 403(b) Plan. Preamble on pages five and six expand the problem caused by the IRS' interpretation of EGTRRA back in 2001 when portability among different kind of plans was greatly expanded, i.e., rollovers among 403(b), 401(k) and 457(b) government plans. Back then, based on a hyper technical interpretation of Code section 402(c)(2), the government concluded that a rollover of after-tax contributions (what the government usually refers to as "employee contributions") from and to a 401(k) or 403(b) plan had to be by direct rollover and could only be made to the same kind of plan or by a 60-day/indirect rollover

3 if to an IRA. That strained reading of the statute is carried over to designated Roth k/b accounts since the contributions to those accounts are made on an after-tax basis. See 1.402A-1, Q&A-5; 1.403(b)-7(a) and 1.408A-10, Q&A-5. From a practical perspective, this means that a participant who wants to do a rollover from his prior employer's 401(k) plan to his current employer's 403(b) plan will not be able to do so with respect to any designated Roth 401(k) contributions in his former employer's plan. This simply will be a trap for the unwary. Apparently not satisfied with this degree of complexity, these proposed distribution regulations will permit a participant that receives a non qualified distribution from a Roth k/b account to rollover only the taxable portion, i.e., the earnings, to another plan if the receiving plan does additional reporting to the government. It is not clear from these proposed regulations if the partial 60-day/indirect rollover is limited to "like" plans. It appears to us that it is not so limited. It is clear that the five-taxable-year period of the distributing plan does not apply to this special rollover. See 1.402A-1, Q&A-5(c) and 1.402A-2, Q&A-3. We think that if these distribution regulations become final in their current form, there will be three kinds of rollovers: 1. Direct rollover between "like" plans. 2. Direct rollover or 60-day/indirect rollover by a plan participant to a Roth IRA. 3. Partial rollover by a plan participant of taxable earnings to a plan which, it appears, does not have to be a "like" plan. Amounts from a designated Roth k/b account may be rolled over to a Roth IRA even if the participant has an AGI ("adjusted gross income") which would otherwise prevent him from having a Roth IRA. These rules are applicable beginning 1/1/2006. See 1.408A-10, Q&A-2. Finally, the rollover rules explicitly provide that they are effective beginning 1/1/2006. See 1.402A-5(e). 4. Separate 5 Year Periods for Roth IRAs. Preamble on pages six and seven confirms our reading of the statute that the five-taxableyear period to determine whether or not a distribution is qualified, i.e., all of it is non taxable, is separately determined for Roth k/b accounts and Roth IRAs. For example, assume that a Roth k/b account is started in After 2010 and assuming other distribution requirements are met, a distribution from the designated Roth k/b account would be tax free. However, if a distribution were taken from that account and rolled over to a new Roth IRA and the participant never had a Roth IRA before, a new fivetaxable-year period begins for the Roth IRA. As a planning matter, any plan participant making Roth k/b contributions to a plan beginning in 2006 should probably, if eligible, begin a Roth IRA in 2006 to avoid this problem. The problem may, of course, be that the plan participant's AGI is too high to permit making Roth IRA contributions in See 1.408A-10, Q&A-4.

4 Generally each plan with a Roth k/b account has a separate five-taxable-year period to calculate, but direct rollovers between plans will permit the use of the earlier period from either plan for the entire Roth k/b account in the plan that received the rollover. Once begun, the five-taxable-year period for that plan is not redetermined if there is a complete distribution with later designated Roth contributions, a QDRO or other circumstance. See 1.402A-1, Q&A-4(b) & (c). Finally on this issue, the preamble confirms that a rollover from a Roth IRA to a designated Roth k/b account is not permitted. 5. Recordkeeping & Disclosure Requirement. Preamble on pages eight and nine provides that the plan administrator or other responsible party is required to keep track of the first of the five-taxable-year period and of the amount of the designated Roth k/b contributions and provide that information upon a direct rollover or employee request within 30 days. In the context of a non Erisa 403(b), we think that means the insurer that issued the 403(b)(1) annuity or the custodian of the 403(b)(7) custodial account. The receiving entity or individual may rely on the information received. To provide time to modify recordkeeping systems, these requirements will become applicable with the 2007 taxable year. For 2006, the government says that it expects that the entity receiving a rollover will require a certification from the distributing entity that the distribution is from a designated Roth k/b account and the amount of the distribution that is a designated Roth k/b contribution. See 1.402A-2, Q&A-1. Upon a direct rollover, the distributing plan administrator or other responsible party will have to provide within 30 days: 1. A statement with the first of the five-taxable-year period and portion of rollover that is Roth k/b contributions, or 2. A statement that the distribution is a qualified Roth k/b distribution. If not a direct rollover, the plan participant may request the information above. For a 60-day/indirect rollover to a plan, not an IRA, of only the taxable earnings of a distribution, the recipient plan administrator must notify the IRS of that receipt by the time the IRS Form 1099-R is due from the distributing plan. This new notice to the IRS will have to include: 1. Participant's name. 2. Participant's social security number. 3. Amount rolled over. 4. The year in which the rollover contribution was made to the recipient plan. 5. Such other information that the IRS determines. See 1.402A-2, Q&A-3.

5 6. Tax Reporting Requirement. Preamble on page 9 provides that it is expected that a separate Form 1099-R will be required of a distribution from a designated Roth k/b account and that the form will have to include the amount of the distribution, the taxable amount of the distribution and the first year of the five-year-taxable period. 7. Correction of Excess Deferrals. Preamble on page 9 provides for distribution of excess designated Roth k/b contributions by April 15 of the following year, i.e., contributions made in excess of the 402(g) limit ($15,000 in 2006). If the excess is not distributed by April 15, then that amount will be treated as taxable when distributed. This rule has the effect of taxing the excess twice: once in the year made since it is an after-tax designated Roth k/b contribution and once in the year distributed. Gap Period Income. The requirement found in the final 401(k) regulations that are effective in 2006 concerning gap period earnings are also applicable to corrective distributions of designated Roth k/b contributions, i.e., generally, the corrective distribution has to include earnings from the end of the year until the date of the corrective distribution. This is confusing since the proposed distribution regulations provide that the gap period rules apply to taxable years beginning on or after January 1, See 1.402(g)- 1(e)(5((i). 8. Defaulted Loan. A plan loan taken with Roth k/b account funds which defaults and is not brought up to date by the end of the applicable grace period will be treated as a taxable deemed distribution even if the deemed distribution occurs after all other requirements are met to permit a qualified Roth k/b distribution. While not explicitly stated in the proposed distribution regulations, we do not think this means that the entire outstanding loan amount at default is a taxable deemed distribution. We think this means that a prorata amount (proportioned between Roth k/b contribution and earnings) is taxable upon the deemed distribution. See 1.402A-1, Q&A Effective Date. Preamble on page 10 provides for generally planned effective date of taxable years beginning in 2007, but certain things are effective as of January 1, 2006 when the statute (Code section 402A) is effective: (i) separate accounting requirement, (ii) rollover limitations, and (iii) corrective distribution of 402(g) excesses. The proposed Roth 403(b) distribution regulations will be effective when the other proposed 403(b) regulations are effective which is still planned for January 1, We may rely on these proposed distribution regulations immediately. See 1.402A-1, Q&A-14 and 1.402A-2, Q&A-4.