Feds Clarify Roth Accounts Tax Liability

January 26, 2006 (PLANSPONSOR.com) - Federal officials have proposed new rules to clarify how distributions from Roth 401(k) and 403(b) plans are to be taxed.

A news release from the Internal Revenue Service (IRS) said the proposed rules  (REG-146459-05) indicate that Roth 401(k)s follow the qualified plan rules for distributions and rollovers. The new release also covers the taxing of nonqualified distributions and separate accounting.

According to the new document, a qualified distribution from a designated Roth account is excludable from gross income. To be a qualified Roth distribution, the amounts must meet certain requirements, including having been held for five tax years, been made after the participant reaches age 59 1/2, dies, or becomes disabled. Roth distributions can only be rolled over to other Roth plans or Roth individual retirement accounts (Roth IRAs).

Nonqualified distributions, under the proposed rules, would be taxed under either Sections 402 or 403(b)(1), treating the designated Roth account as a separate contract under Section 72. If a distribution is not qualified, the distribution would be taxed under Section 72 on income earned on the account, but not on the investment in the account, or basis, under the proposal.

Ordering Method

The IRS said in the proposal that the nonqualified distributions do not follow the Roth IRA ordering method of nontaxable basis first and then taxable earnings on the basis. In an example provided by officials, if an employee’s account in a Roth 401(k) contained $9,400 of designated Roth contributions and $600 of earnings. If the employee takes a nonqualified distribution of $5,000, that distribution would consist of $4,700 of nontaxable Roth contributions and $300 of taxable earnings.

The guidance said the proposed regulations sought to clarify that “any transaction or accounting methodology involving an employee’s designated Roth account and any other accounts under the plan or plans of an employer that has the effect of directly or indirectly transferring value from another account into the designated Roth account violates the separate accounting requirement under section 402A.”

Reporting and recordkeeping requirements in the proposed regulations do not become effective until the beginning of the 2007 tax year, the IRS pointed out, in order to give employers enough time to develop systems to comply.

Roth 401(k) and 403(b) plans were authorized by the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA). Section 402A, added by EGTRRA, allows employees to make after-tax designated contributions to separate accounts in the 401(k) and 403(b) plans that have been amended to permit Roth contributions.

Designated Roth contributions allow plan participants to designate all or a portion of their elective contributions, under a Section 401(k) plan or a Section 403(b) annuity, as Roth contributions. While the initial contributions are made from after-tax income, “qualified distributions,” plus earnings from the plans, would be completely tax-free.

Comments on the proposal are due by April 26 and can be mailed to: CC:PA:LPD:PR (REG-146459-05), Room 5203, Internal Revenue Service, POB 7604, Ben Franklin Station, Washington, DC 20044. Submissions may be hand delivered Monday through Friday between the hours of 8 a.m. and 4 p.m. to: CC:PA:LPD:PR (REG-146459-05), Courier’s Desk, Internal Revenue Service, 1111 Constitution Avenue, N.W., Washington DC.