The IRS has just issued proposed regs to prepare for a major, new retirement-savings option:  designated Roth contributions to 401(k) plans.  Starting next year, employees will be able to designate all or part of their contributions to their 401(k) plans on an after-tax basis, which will make most distributions tax free.

·         Comment. The Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) first authorized these accounts but delayed their effective date until tax years beginning after December 31, 2005.  The IRS said that it is issuing rules now to give employers plenty of time to amend their plans.  No plan sponsor is forced to amend its plan but no employee may elect after-tax Roth contributions without that amendment.

Designated Roth contributions

Under Code Sec. 401(k), employees are permitted to elect whether to receive a portion of their compensation in cash or instead have it deferred to a qualified trust under one of several plans.  Contributions are generally taken out before taxes are calculated and the amounts are not includible in gross income.  Designated Roth contributions, like their traditional counterparts, are elective contributions under cash or deferred arrangements, but qualified distributions will be excludable from gross income.

·         Comment.  The regs also permit after-tax contributions to 403(b) plans, but not to the 457 plans that apply to government employees.

Plan requirements

The proposed regs describe three principal characteristics of Roth contributions:

 First:  The employee must make an irrevocable designation of a Roth contribution when he or she makes the cash or deferred election.

·         Comment.  This means that there will be no opportunity to shift the money to a traditional 401(k) plan within the year if the employee determines the need for current-year tax savings.

 Second:  Contributions must be treated by the employer as includible in the employee’s gross income for the purpose of all taxes, as if the employee had received cash instead.

 Third:  Roth contributions must be maintained by the plan in a separate account.  Separate accounting rules require that contributions be credited and debited to a designated account maintained for the employee.  The plan must maintain records of undistributed Roth contributions for each account and credits and charges must be separately allocated on a reasonable and consistent basis to the Roth and other accounts.  The separate accounting requirement would be in force until all Roth contributions had been distributed.

·         Comment.  The separate accounting requirement is of concern to the IRS because of information collection.  The IRS is interested in comments that would help it determine the effectiveness of these requirements, as well as the burden of compliance.

Qualified Distributions

To qualify for the exclusion from gross income, a distribution from a Roth account must be made at least five years after the end of the tax year in which contributions were made.  Distributions may also be taken:

·         On or after the recipient reaches age 59 ½,

·         For a qualifying first-time home purchase expense,

·         At or after the death of the contributor, or

·         On account of disability.

Distributions from Roth 401(k) accounts will only by permitted to be rolled over into other Roth accounts, whether another 401(k) plan or a Roth IRA.

Other requirements

Many of the same requirements in place for elective pre-tax contributions would still hold for designated Roth contributions.  These include the nonforfeitability and distribution restrictions, as well as the actual deferral percentage (ADP) test.  In addition, the proposed regs would permit highly compensated employees with excess contributions who had elected both pre-tax and Roth contributions to allocate the excess amounts between the two.  The IRS indicates in the preamble to the proposed regs that more guidance on Roth contributions will follow, including guidance on recovery of an investment in the contract associated with Roth contributions.

·         Comment.  Unlike Roth IRAs, the Roth contribution option is available to all 401(k) participants with no AGI limits.  Predictions are that this difference alone will make Roth 401(k)s very popular.

·         Comment.  Unlike Roth IRAs, Roth 401(k)s would require investors to begin mandatory distributions upon reaching age 70 ½.  Because funds invested in these 401(k) plans may be rolled over into Roth IRAs, participants have an option that will allow them to avoid mandatory distributions.  There is a question as to whether the IRS will permit funds currently invested in traditional 401(k) contracts to be rolled over into Roth contracts, with taxes due in the year of the conversion.  This issue may be raised in comments and future hearings.