The Treasury Department and the Internal Revenue Service recently issued final regulations relating to Roth 401(k) and Roth 403(b) accounts.
These final regulations provide guidance on the taxation of distributions from designated Roth accounts and other related issues. A designated Roth account is a separate account under a 401(k) plan or a 403(b) plan into which designated Roth contributions are made.
Designated Roth accounts were put in place in EGTRRA 2001, but that provision was not effective until tax years beginning after 2005. Also, because of EGTRRA’s sunset provision, many employers were reluctant to put plans with designated Roth accounts into effect. Now that the pension provisions of EGTRRA have been made permanent by the Pension Protection Act of 2006, more employers may be interested in putting designated Roth accounts into effect.
The taxation of a distribution from a designated Roth account depends on whether the distribution is a qualified distribution. A qualified distribution is not includable in an employee’s gross income. It is generally a distribution that is made after a 5-taxable-year period of participation and that:
(1) Is made on or after the date the employee reaches age 59 1/2 .
(2) Is made after the employee’s death.
(3) Or, is due to the employee becoming disabled.
A designated Roth account is treated as a separate account under a 401(k) plan or a 403(b) plan for which separate accounting of contributions, gains, and losses must be maintained.
The final regulations provide that distributions from a Roth 401(k) or Roth 403(b) that are not qualified distributions will not be treated the same way similar distributions from a Roth IRA are treated. Distributions from Roth IRAs that are not qualified distributions are generally treated as a recovery of basis first and then as taxable distributions, while Roth 401(k) and Roth 403(b) distributions that are not qualified distributions are generally taxed on a pro rata basis. This treatment is different from the way distributions from a Roth IRA are treated.
The Service noted in the preamble to the regulations that while the Internal Revenue Code provisions for Roth IRAs and designated Roth accounts are similar, they are not identical. Specifically, Section 402A, which governs designated Roth accounts, does not have the ordering rules contained in Section 408A, which governs Roth IRAs. Note, however, that amounts in a designated Roth account can be rolled over into a Roth IRA, and then these funds would be subject to the distribution rules of Roth IRAs.
The regulations also provide that the 5-taxable-year period begins on the first day of the employee’s taxable year for which the employee first made contributions to the Roth account and ends when 5 consecutive years have elapsed. If a direct rollover from another Roth account has been made, the 5-year period for the recipient plan begins on the first day of the employee’s taxable year the employee made a Roth contribution to the first plan, if that date is earlier.
The Final Regulations were published in the April 30, 2007, edition of the Federal Register. The citation is 72 Fed. Reg. 21103.