With only hours to spare before plans were able to commence allowing Roth deferrals, the IRS issued the final regulations on the Roth 401(k) option. Unfortunately, the regulations do not include guidance on the more pressing issues of distributions and taxation. The IRS indicated that they would soon issue regulations addressing these issues under Code §402. In general, the final regulations did not make significant changes to the proposed regulations issued on March 2, 2005. However, the regulations did address several issues practitioners had raised and clarified a few others.

Roth 401(k). A 401(k) plan may include a provision that permits a participant to make an after-tax deferral contribution rather than a pre-tax contribution. Unlike a pre-tax contribution in which the income taxes are deferred, a distribution from a Roth account is tax-free if it is a qualified distribution. A distribution is qualified if it is: (1) on account of a qualifying distribution event (age 59½, death or disability), and (2) the participant has satisfied the 5-year non-exclusion period.

Designated Roth Contributions. The final regulations define a Roth contribution as an elective contribution under a 401(k) plan that: (1) the participant, at the time of the contribution, irrevocably designates in lieu of a pre-tax contribution as a Roth contribution; (2) the employer treats as includible in gross income (i.e., nondeductible); and (3) the plan maintains in a separate account.

Roth Only 401(k) Plan. Since the regulations require a participant to designate a Roth contribution as made in lieu of a pre-tax contribution, the plan must offer the participant the pre-tax contribution option. Accordingly, an employer may not sponsor a 401(k) plan that only offers the Roth option. Of course, an employer may limit 401(k) deferrals to pre-tax deferrals.

Separate Account Requirement. A plan permitting Roth contributions must establish a separate account (i.e., separate source) for purposes of tracking Roth contributions, earnings and distributions. The plan must maintain the account until the plan has completely distributed the account. The plan also must allocate gains, losses and expenses on a reasonable and consistent basis. Furthermore, the plan may not allocate forfeitures to the Roth account. Accordingly, the Roth account should only include Roth contributions, rollovers from other Roth 401(k) or 403(b) plans and earnings on such contributions.

Elective Deferral Requirements. With the exception that the Roth contribution is made on an after-tax basis, the Roth contribution is treated like any other elective deferral for purposes of the 401(k) requirements. Therefore, a Roth contribution is subject to the annual deferral limitation (Code §402(g)), ADP testing, distribution restrictions and the non-forfeitability requirement.

Catch-up Contribution. As an elective deferral, a Roth contribution in excess of a prescribed limit (e.g., 402(g) limit) will qualify as a catch-up contribution. Accordingly, a participant who is age 50 or older in 2006 may be able to defer as much as $20,000 ($15,000 402(g) limit plus $5,000 catch-up limit).

Required Minimum Distributions. Although participants in a Roth IRA are not subject to the required minimum distribution (RMD) rules during the participant’s lifetime (the death RMD rules do apply to the beneficiaries), Roth 401(k) plan accounts are subject to the RMD rules.

Note: A Roth 401(k) participant could avoid the application of the lifetime RMD rules by rolling his/her account to a Roth IRA.

Frequency of Deferral Elections. A Roth 401(k) is subject to the same rule applicable to pre-tax deferrals regarding frequency at which a plan must permit deferral changes – the plan must allow a participant to change his/her deferral election at least once per year.

Automatic Enrollment (Negative Election). A 401(k) plan may apply an automatic deferral feature to Roth contributions. However, since a plan including a Roth feature must also include the pre-tax feature, the plan must designate whether the automatic deferral contributions will be pre-tax or Roth.

Note: Plans utilizing the automatic deferral feature likely will designate the automatic deferral contributions as pre-tax because: (1) the provision likely will apply to the non-highly compensated participants, (2) the pre-tax option generally is more affordable for the non-highly compensated participants, and (3) the affected participants will be less likely to elect against the automatic deferral contribution since they will receive a deduction for a pre-tax deferral.

Direct Rollover. The direct rollover rules contain a $200 threshold, below which a plan does not need to apply the direct rollover rules. In applying the rule to a plan that includes a Roth feature, the plan may treat the pre-tax account and the Roth account as if they were two separate plans. Furthermore, a plan with a Roth or a pre-tax account that is less than $200 may treat the plan as two plans for purposes of applying the automatic rollover requirements. For example, if a participant terminates employment with a $4,100 account ($4,000 pre-tax and $100 Roth), the plan would not need to apply the direct rollover rules nor the automatic rollover rules to the Roth account. However, the direct rollover rules and the automatic rollover rules would apply to the pre-tax account (assuming the employer did not amend the plan to avoid the application of the automatic rollover rules).

Corrective Distributions. A corrective distribution of a Roth contribution is never a qualified distribution. Accordingly, although the return of the Roth contribution is not taxable, the earnings are includible in gross income. A plan may permit a highly compensated participant who is receiving a corrective distribution of excess contributions (ADP test failure) and who made both pre-tax and Roth deferrals in the year of the failure, to elect whether he/she will receive the corrective distribution from the Roth or the pre-tax account. However, the plan does not need to provide the participant this election. The plan may provide that the corrective distribution is coming from one or the other of the accounts.

Note: Since the regulations only provide a short window within which to complete the testing and the corrective distributions, it is unlikely that employers will want to provide highly compensated participants with the choice.

Partial Distributions. Although not addressed in the final regulations, the preamble to the regulations indicates that a 401(k) plan with Roth contributions may permit a participant to elect the account (pre-tax or Roth) from which it receives a partial distribution. Of course, a plan may dictate the ordering of distributions rather than permit the participant the election.

Effective Date. Code §402(A) is effective for taxable years beginning after December 31, 2005. Therefore, a plan may permit participants to commence making Roth contributions on January 1, 2006 irrespective of the plan year. The final regulations are effective for plan years beginning after December 31, 2005. However, for a plan with a fiscal year that implements the Roth feature before its first plan year beginning in 2006, the employer may rely on the final regulations.

Plan Amendments. The regulations contain no guidance on the timing of Roth 401(k) plan amendments. However, since the Roth 401(k) option is a voluntary EGTRRA option, the IRS has indicated that the employer has until the end of the plan year in which it implements the option to amend the plan. Therefore, if an employer with a calendar year plan added the option in 2006, the employer would need to amend the plan by December 31, 2006. However, if an employer with a plan year ending June 30, 2006 and which added the option on January 1, 2006, the employer would need to amend its plan by June 30, 2006. The IRS has indicated that it will issue a model amendment but the date for its release has not yet been announced. SunGard has provided its clients an amendment they may use to amend their plans to add the option.

During January, SunGard is presenting half-day programs on Roth 401(k) plans. The program not only explains the various requirements applicable to Roth 401(k) plans but also illustrates situations in which the Roth 401(k) option provides a better deferral opportunity than the pre-tax deferral. As an added bonus, we are presenting a half-day program on distribution and taxation rules. For a complete listing of the cities and dates, visit our Web site.