Final Roth 401(k) Distribution Regulations

By Ed Slott

E-mail Story
Print Story
MAY 2008 - On April 30, 2007, the IRS published final regulations on the taxation of distributions from designated Roth accounts, better known as Roth 401(k)s and Roth 403(b)s. This article mentions only the Roth 401(k), but the information applies to Roth 403(b)s as well. These final regulations for the taxation of Roth 401(k) distributions are effective April 30, 2007, and generally apply to tax years beginning on or after January 1, 2007. Similar regulations will apply to Roth 403(b) plans when the final 403(b) regulations are released.

Recap of the Roth 401(k) Contribution Rules

The final regulations for Roth 401(k) contributions, dated December 30, 2005, have been effective since January 1, 2006, when these accounts first became available.

The Roth 401(k) option may be offered by an employer plan. It is not a stand-alone retirement plan, and is governed by the same rules as other 401(k) plans. It is subject to the same nondiscrimination tests, contribution limits, and distribution restrictions as other funds in a 401(k) plan. An employer is not required to offer a Roth option to its employees, and there are no income limits for employees’ Roth 401(k) contributions, although some highly compensated employees may not be able to contribute the full amount, just as they cannot contribute the full amount to a 401(k).

Roth 401(k) contributions are salary deferrals, but they are made after-tax. The amount deferred to a Roth 401(k) is subject to the same income tax withholding as the employee’s take-home pay, unlike deferrals to a 401(k), which are not taxed.

Examples. Lou’s employer has a 401(k) plan and now offers a Roth 401(k) option. Lou earns $50,000 a year and currently has 5% of his salary deferred to the 401(k) plan.

401(k). The deferral of $2,500 is pre-tax. It reduces Lou’s take-home pay by $2,500, and his employer does not withhold any federal taxes out of the $2,500. It is as if Lou were earning only $47,500 a year, because he pays tax on only $47,500.

Roth 401(k). Lou decides to change his 5% deferral to the Roth 401(k). The deferral of $2,500 is now after-tax. His employer must calculate federal withholding on Lou’s full salary of $50,000. Lou pays tax on his full salary even though he receives only $47,500. Lou is actually paying more taxes on the money he takes home each year.

The contribution limits are the same as the elective contribution limits for the employer plan. And, just as the contribution limits for a traditional IRA and a Roth IRA are combined so taxpayers cannot contribute more than $5,000 to all their IRAs if they are under age 50, the Roth 401(k) and the 401(k) limits are combined. For 2008 the maximum contribution amount is $15,500 plus a $5,000 catch-up contribution if the employee is age 50 or older.

Example. In 2008 Mike is under age 50 and does not qualify for catch-up contributions. The 401(k) plan lets him defer $15,500 of his compensation, and his employer also offers a Roth 401(k). The total deferral to both plans cannot exceed $15,500. Mike decides to defer the maximum to his retirement account and elects to defer $10,000 to the Roth 401(k) account and the balance of $5,500 to the 401(k) account.

Although contributing to a Roth 401(k) doesn’t limit one’s ability to contribute to a traditional or Roth IRA, being covered by a company plan could affect the ability to deduct a traditional IRA contribution, depending on income. Those who qualify can contribute to both Roth 401(k)s and Roth IRAs to quickly build their tax-free retirement savings.

Example. John and Nancy are married and file a joint return. Their joint income is $125,000, so they each qualify to make Roth IRA contributions. They are also both over 50 years old, so they both qualify to make catch-up contributions. If John and Nancy work for companies that offer Roth 401(k)s, they can contribute a total of $53,000 to their Roth IRAs and Roth 401(k)s for 2008. Here is how they get to the $53,000 total contribution amount for one year:
2008 Roth 401(k) contributions: $15,500 + $5,000 catch-up = $20,500 each 2008 Roth IRA contributions: $5,000 + $1,000 catch-up = $6,000 each Total = $26,500 each or $53,000 for both, all in one tax year.

Only elective salary deferrals or rollovers from other Roth employer plans can go into a Roth 401(k), and the election to make Roth 401(k) contributions (these are after-tax contributions) is irrevocable. Taxpayers can’t change their minds and recharacterize. For example, funds contributed to a Roth IRA can be recharacterized to a traditional IRA, and funds contributed to a traditional IRA can be recharacterized to a Roth IRA. But funds contributed to a 401(k) cannot be either recharacterized as a Roth 401(k) contribution or transferred to a Roth 401(k).

A Roth 401(k) cannot be the only plan that an employer offers; it must be paired with a 401(k) plan. The Roth 401(k) contributions are made in lieu of elective pre-tax contributions that the employee is otherwise eligible to make under the plan.

Employers must maintain and account for Roth 401(k) contributions in a separate account. Forfeitures and employer-match contributions cannot be allocated to the Roth 401(k) account. The employer must keep track of gains, losses, contributions, and distributions in the Roth 401(k) account, and must be able to determine the employee’s basis in the account.

If the plan allows Roth 401(k) rollover contributions, they can be accepted only from another Roth employer account. The plan cannot accept rollovers from an individual IRA or Roth IRA. Nor can the employee convert amounts currently held in the 401(k) plan to the Roth 401(k).

Roth 401(k) Required Minimum Distributions

Distributions from a Roth 401(k) will be subject to the plan distribution rules. The plan participant cannot take the funds out unless the plan allows it. The 401(k) required minimum distribution (RMD) rules also apply to the Roth 401(k) when the plan participant reaches his required beginning date. An employee can get around this by rolling the Roth 401(k) monies into an individual Roth IRA, where there are no RMDs. If the rollover is not done until the year of the first RMD, the RMD will have to be distributed from the plan before doing the rollover.

Example. Ben has retired and left his retirement funds in the company plan. He must take an RMD this year. Ben’s Roth 401(k) has $40,000, and his 401(k) has $340,000. His RMD for the year will be based on the total balance in both plans, $380,000. Had Ben rolled the $40,000 Roth 401(k) balance over to a Roth IRA in a prior year, his RMD for this year would be based only on his 401(k) balance of $340,000.

Qualified Roth 401(k) Distributions

Qualified distributions are not subject to taxes or penalties. A distribution is qualified if the Roth 401(k) account is held for more than five years and any of the following applies:

  • The employee is age 59 Qs or older;
  • The employee is deceased; or
  • The employee is disabled.

A qualified distribution is considered to consist entirely of basis. When these funds are transferred to another employer’s Roth 401(k) or to an individual Roth IRA, they go into the new account as basis and are available for distribution income tax–free.

Example. Rachel established her Roth 401(k) with her current employer 10 years ago. Now, at age 62, she is taking early retirement and wants to supplement her income until she starts collecting Social Security. Any distribution Rachel takes from her Roth 401(k) plan will not be subject to income tax because the plan was established more than five years ago and Rachel is past the age of 59 Qs .

A distribution that is not a qualified distribution is subject to the pro-rata rule; it is not subject to the ordering rules used in a distribution from an individual Roth IRA. The nontaxable amount of the distribution is generally determined by dividing the employee’s deferrals (basis) by the balance in the Roth 401(k) account and multiplying the amount distributed by the result.

Example: 401(k). Kathy has deferred a total of $30,000 to her Roth 401(k) and has a total balance in the account of $40,000. She then takes a distribution of $12,000. A total of $9,000 of the distribution will be tax-free ($30,000/$40,000 = .75) ($12,000 x .75 = $9,000).

This differs from a Roth IRA, where ordering rules apply. Under the ordering rules for Roth IRA distributions, the funds are deemed to come out in this order:

  • First from Roth IRA contributions. Roth IRA contributions can be withdrawn at any time for any reason, tax- and penalty-free.
  • Next, from Roth IRA conversions (taxable amounts first, then nontaxable amounts).
  • The balance of the distributions is deemed to come from earnings on Roth contributions or conversions.

Example: Roth IRA. Kathy also has a Roth IRA with $30,000 of contributions and a total account balance of $40,000. She then takes a distribution of $12,000. Under the Roth IRA ordering rules, the $12,000 is deemed to come first from contributions; Kathy’s contributions total $30,000, so the distribution is tax-free to Kathy.

Rollovers

Roth employer accounts can be rolled over to individual Roth IRAs, but individual Roth IRAs cannot be rolled over to Roth employer plans. Employee deferrals to the Roth 401(k) are after-tax contributions and governed by the rules applicable to after-tax contributions in an employer plan. Roth 401(k) funds can be rolled over to another employer’s Roth plan only if the receiving plan allows it. The amount rolled over depends on whether the transfer was done as a direct rollover (a trustee-to-trustee transfer) or a 60-day rollover.

Direct rollover (trustee-to-trustee transfer). The entire plan balance can go to an employer Roth plan or to an individual Roth IRA.

Rollover (60-day rollover). Only taxable amounts can be rolled over to another Roth employer plan, or the entire plan balance can go to an individual Roth IRA. The rollover must be completed within 60 days.

If the employee does a partial 60-day rollover of a nonqualified distribution to an existing individual Roth IRA, the amount rolled into the Roth IRA is deemed to come first from taxable amounts distributed from the Roth 401(k). This means that the employee is rolling the taxable earnings portion into the Roth IRA first, and the balance of the distribution comes from the tax-free part.

Example. Dave is changing jobs and wants to transfer his existing 401(k) of $150,000 and his Roth 401(k) of $25,000 to his new employer’s plan. His new employer plan allows him to transfer his 401(k) and Roth 401(k) balances into the employer’s plan. The $25,000 Roth 401(k) balance includes $5,000 of earnings. The distribution of the Roth 401(k) funds is not a qualified distribution because the funds have not been held for five years.

Direct rollover. Dave does a direct rollover of the total balance from his previous employer into the current employer’s plan. The total amount transferred is $150,000 into the 401(k) and $25,000 into the Roth 401(k).

60-day rollover. Dave does a 60-day rollover of the total balance from his previous employer. He receives a rollover check, but because this is a 60-day rollover (as opposed to a direct rollover), any pre-tax amount in the distribution is subject to mandatory 20% withholding, the same as any eligible rollover distribution from a 401(k).

The entire balance in Dave’s 401(k) can be rolled over, but Dave receives only 80% of that amount ($120,000), because the distribution from the 401(k) was subject to withholding. He receives only $24,000 from the Roth 401(k). Only $1,000 of the $25,000 Roth 401(k) rollover needs to be withheld [20% of the $5,000 of Roth 401(k) earnings].

Dave can replace the withheld funds with other funds he has if he wants to roll over the entire plan balance. Because he is doing this transfer as a 60-day rollover, only the taxable amounts in the Roth 401(k) (the $5,000 of earnings) can be rolled over to the new Roth 401(k). To complete the rollover, Dave must roll over the funds he received (plus funds to cover the withheld amounts) to his new employer’s 401(k) and Roth 401(k) within 60 days. Dave rolls over the net amounts into his current employer’s plan.

The total amount that Dave can roll over to the new 401(k) is $150,000. The amount that he actually rolls over is $120,000 ($150,000 less the 20% mandatory withholding of $30,000).

The total amount that can be rolled over to the new Roth 401(k) is $5,000. The amount that Dave actually rolls over is $4,000 ($5,000 less the 20% mandatory withholding of $1,000).

Any funds that Dave has not rolled into his new employer plan can be rolled over to his Roth IRA if he completes the rollover within 60 days. This amount would include the after-tax amount of $20,000 from his Roth 401(k) and the mandatory withholding amounts that he didn’t roll over into his new employer’s plan [$30,000 from the 401(k) and $1,000 from the Roth 401(k)]. Funds that Dave rolls over to his Roth IRA can continue to grow tax-free.

Partial 60-day rollover of the Roth 401(k). Dave does a direct rollover of his 401(k)’s $150,000 balance into his new employer’s plan. He takes a full distribution of the $25,000 Roth 401(k) balance and does a 60-day rollover of only $10,000 to his Roth IRA. Dave’s distribution from the Roth 401(k) will be subject to mandatory 20% withholding, but only on the earnings of $5,000 ($5,000 x 20% = $1,000) in the account. No withholding is required on the tax-free portion of the distribution (the $20,000 of after-tax contributions). Dave receives a check for $24,000 ($25,000 account balance less $1,000 withholding). The $10,000 deposited in the Roth IRA will be deemed to first be the $5,000 taxable balance in the Roth 401(k), and the $5,000 remaining will be added to the basis in the Roth IRA. The remaining $14,000 that Dave did not roll over will be treated as a tax-free distribution. The end result is that Dave has executed a series of transactions that are nontaxable (because his total taxable amount ends up being rolled into his Roth IRA), but he has been forced to prepay $1,000 in income tax withholding.

The moral of the story: Do not take a nonqualified distribution from any Roth account, particularly a Roth 401(k) account.

Five-Year Clock for Qualified Distributions

Roth 401(k)s have their own five-year holding rules. Unlike individual Roth IRAs, where there is only a single five-year period that starts with the establishment of the owner’s first Roth IRA, Roth 401(k)s have a separate five-year holding period for each employer’s Roth account. Taxpayers who work for different companies and participate in Roth 401(k) plans at more than one company will have a different five-year period for each plan.

These final regulations (and the examples below) spell out how the five-year holding period is determined in each situation, depending on how the funds were transferred (direct or 60-day rollovers) and where the funds were transferred to [Roth 401(k) or Roth IRA].

Rollovers from Roth 401(k)s to new Roth 401(k)s. The rules are different for 60-day rollovers and for direct rollovers, and they are more favorable for direct rollovers. When funds are moved to a new employer’s Roth 401(k) plan in a direct rollover, the new plan will use the earlier start date of the five-year holding period of the two plans.

Example: Direct rollover (trustee-to-trustee transfer) to a new Roth 401(k). Edna started contributing to her Roth 401(k) in 2006. In 2009 she gets a new job; that employer also has a Roth 401(k) plan. She does a direct rollover of her entire Roth 401(k) to the new employer’s plan. The beginning date of Edna’s holding period in the old plan was January 1, 2006, and the beginning date in the new plan is January 1, 2009. Because of the direct rollover, Edna can use the earlier of the two dates as the beginning date of her holding period. The beginning date for the new plan will be January 1, 2006.

When those same funds are transferred as a 60-day rollover, the five-year holding period cannot be carried over to the new plan. The employee will use the holding period of the receiving plan.

Example: 60-day rollover to a Roth 401(k). Consider the same scenario as above, except Edna did a 60-day rollover of the taxable amount only, into the new employer’s Roth 401(k) plan. She cannot carry over the beginning date of the holding period from her old plan, so the new beginning date of the holding period is January 1, 2009, the date applicable in the receiving plan.

Rollovers from Roth 401(k)s to Roth IRAs. The five-year holding period is never carried over to an individual Roth IRA. The Roth 401(k) funds will be governed by the five-year rule applicable to the Roth IRA. If the Roth IRA has already satisfied the five-year period, then the employer funds are deemed to have also met the five-year period, even if they were in the Roth 401(k) for only a year. This is just one more reason for qualifying individuals to establish a Roth IRA. If they don’t qualify now, they will qualify in 2010, when the restrictions on converting to a Roth IRA are lifted and taxpayers can establish Roth IRAs by doing conversions.

Example: Rollover to an existing Roth IRA. Consider the same scenario as the direct rollover example, except Edna did a rollover of the total amount from the Roth 401(k) in 2009, to her individual Roth that she established in 2004. Because Edna cannot carry over the beginning date of the holding period in the Roth 401(k) plan, she must use the beginning date in the Roth IRA. In this case, the Roth has been open for more than five years, so the Roth 401(k) funds she rolled over are now considered to satisfy the five-year holding period even though they were in the Roth 401(k) for only three years. This is another reason for anyone who qualifies to open a Roth IRA now, and get the five-year clock ticking.

Example: Rollover to a new Roth IRA. Same scenario as the direct rollover example, except Edna did a 60-day rollover of the total amount from the Roth 401(k) to a Roth IRA that she first establishes in 2009 at the time of the rollover. Because Edna cannot carry over the beginning date of the holding period in the old plan, she uses the beginning date in the Roth IRA. In this case, the Roth IRA has just been established, so the five-year holding period for the Roth 401(k) funds starts over as of 2009. Edna loses the three years she had in the Roth 401(k).

Example: Rollover of qualified distribution to a new Roth IRA. Returning to the earlier example of Rachel, she established her Roth 401(k) with her current employer 10 years ago. Now, at age 62, she is taking early retirement and wants to supplement her income until she starts collecting Social Security. Rachel never had a Roth IRA, so she does a direct rollover of her entire Roth 401(k) balance into a new Roth IRA. This Roth IRA will have to satisfy a five-year holding period before Rachel can take a qualified distribution, even though the funds rolled into it have been in the Roth 401(k) for 10 years and she is over age 59 Qs . But the rollover funds from her Roth 401(k) are considered basis in the Roth IRA because they were a qualified distribution from the plan. Under the Roth IRA ordering rules, any distribution Rachel takes is considered to first come from her basis, and distributions of basis will be income tax–free.

Roth 401(k) Beneficiaries

There will be required distributions to the Roth 401(k) beneficiary based on the options available in the plan, but distributions will not automatically be qualified distributions. A qualified distribution has two parts: Death of the account owner satisfies one part; the other part is the five-year holding period. If the Roth 401(k) account owner has not satisfied the five-year holding period, the beneficiary must hold the account for the balance of the holding period before he has a qualified distribution.

Example. George began making Roth 401(k) deferrals in 2007. He dies in 2010. Because the five-year holding period will not be satisfied until 2012, George’s beneficiary will not receive a qualified distribution from the plan until 2012, even though the beneficiary must take required distributions beginning in 2011.

Because the Roth 401(k) is an employer plan, nonspouse beneficiaries may not be able to stretch distributions over their life expectancies. Although the Pension Protection Act of 2006 allows a nonspouse beneficiary to do a direct rollover of employer plan balances to inherited IRAs, the employer plan must allow this option. If the plan does not allow the direct rollover option, beneficiaries will be limited to the distribution options available in the plan. (Five years or a lump-sum distribution are common options for nonspouse plan beneficiaries.)

Tax Reporting of Roth 401(k) Distributions

A Roth 401(k) plan must track the Roth assets in an account separate from the 401(k) assets. The plan administrator or other responsible party must track deferrals to the plan (the after-tax amounts), earnings in the plan (the pre-tax amounts), and distributions (nonqualified distributions are pro rata distributions, so both pre-tax and after-tax balances are affected by a distribution and the beginning of the five-year holding period. When a direct rollover of Roth 401(k) funds is done, all of this information must be furnished to the receiving plan. When a 60-day rollover is done, this same information (except for the date of the beginning of the holding period, because that cannot be transferred to the receiving plan) must be provided to the employee when the employee requests it.

An employer is required to issue a separate Form 1099-R to report distributions from a Roth 401(k). Code B has been added to the list of explanation codes to designate a nonqualified distribution from a Roth 401(k).

Roth IRA Documents Must Be Amended

On May 31, 2007, the IRS released Announcement 2007-55 to remind Roth IRA sponsors that Roth IRA documents will need to be amended if they are to allow for the acceptance of rollover contributions from Roth 401(k) or Roth 403(b) accounts. All advisors whose clients are thinking of rolling over Roth 401(k) balances to Roth IRA accounts should first be sure that the Roth IRA document allows for this type of rollover. A Roth IRA that has already accepted rollover contributions from a Roth 401(k) needed to be amended by December 31, 2007 (Revenue Procedure 2002-10).

Click here to view Advisor Action Plan.

Click here to view Allowable Contributions to Roth 401(k)s.

Click here to view Allowable Rollovers From Roth 401(k)s.


Ed Slott, CPA, Rockville Centre, N.Y., is a nationally recognized IRA expert, speaker, and author of several IRA books, including Your Complete Retirement Planning Road Map (Random House; 2007), and of the monthly newsletter Ed Slott’s IRA Advisor, from which this article is adapted with permission from the author. To order, call 800-663-1340 or go to www.irahelp.com. Copyright 2007.

 

 

 

 

 

 

 



The CPA Journal is broadly recognized as an outstanding, technical-refereed publication aimed at public practitioners, management, educators, and other accounting professionals. It is edited by CPAs for CPAs. Our goal is to provide CPAs and other accounting professionals with the information and news to enable them to be successful accountants, managers, and executives in today's practice environments.

©2009 The New York State Society of CPAs. Legal Notices