Roth contributions, added to the Internal Revenue Code by the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), are effective for taxable years beginning after December 31, 2005. Designated Roth contributions allow for employees to designate all or a portion of their section 401(k) employee deferrals as Roth contributions, which would receive treatment much like Roth IRA contributions (i.e., they would be contributed on an after tax basis, and qualified distributions of those contributions, plus earnings, would be tax free).
These regulations finalize rules that were proposed on March 2, 2005 (See Proposed Regulations Issued Regarding Roth Contributions ), and the summary accompanying the final version indicates the written public comments received as a result and public reaction were generally favorable.
The final regulations, which are generally applicable to plan years beginning on or after January 1, 2006:
- Provide that elective contributions may only be treated as designated Roth contributions to the extent permitted under the plan
- Clarify that, in order to provide for Roth contributions, a qualified cash or deferred arrangement must also offer pre-tax elective contributions (this in response to comments suggesting that plans to be allowed to only offer Roth contributions)
- Retain the rule that, under the separate accounting requirement, contributions and withdrawals of Roth contributions must be maintained in a designated Roth account maintained for the employee, and that the plan must retain a record of the investment in that account. Gains, losses, etc. must be allocated on a “reasonable and consistent” basis to the Roth account and other accounts under the plan.
- State that forfeitures may not be allocated to the Roth account, and no contributions other than designated Roth contributions and rollover contributions described in section 402A(c )(3)(B) can be allocated to a designated Roth account
- Retain the requirement that the Roth contributions are taken into account under the actual deferral percentage test (ADP test) of section 401(k)(3)
- Clarify that Roth contributions can be treated as catch-up contributions and serve as the basis for a participant loan
- Clarify that a direct rollover from a designated Roth account under a qualified cash or deferred arrangement can only be made to another designated Roth account under an applicable retirement plan, or to a Roth IRA described in section 408A
- Retain the rule that a highly compensated employee, with elective contributions that include both pre- and Roth contributions, can elect whether excess contributions are to be attributed to pre-tax elective contributions or designated Roth contributions, though there is no requirement that a plan provide this option
- Retain the rule that a distribution of excess contributions, to the extent it represents a distribution of Roth contributions, is not includible in gross income (income allocable to a corrective distribution of those monies is, however, includible in the same manner as that allocable to a corrective distribution of excess pre-tax elective contributions)
The final regulations also specifically address the application of automatic enrollment to these Roth accounts. The adopting plan must set forth the extent to which default contributions are pre-tax elective or designated Roth contributions – and, to the extent that they are designated Roth contributions, the regulations provide that an “employee who has not made an affirmative election is deemed to have irrevocably designated the contributions (in accordance with section 402A( c)(1)(b)) as designated Roth contributions.”
The final regulations do not provide guidance with respect to the taxation of distributions of designated Roth contributions. Proposed regulations under section 402A that will address those issues, will be issued “in the near future” according to the regulations published on Friday.
The final regulations (only 22 pages long, and half that in terms of substance) are online at http://www.treas.gov/press/releases/reports/roth401k_reg_attch.pdf .