Tax benefits for Roth not fully settled
There is apparently a still open issue relating to qualifying for tax free distributions from a Roth 401(k). The issue arises if EGTRRA -- the 2001 pension reform legislation that, among other things, created Roth 401(k) accounts -- is not extended and relates to the question of whether a distribution from a Roth 401(k) may not meet the five-year requirement for a tax-free withdrawal. IRS speakers at the ABA Tax section meeting in San Diego commented that it may be necessary to roll a Roth 401(k) distribution to a Roth IRA before the amounts distributed qualify for tax free withdrawal. Apparently the IRS believes that you cannot count the calendar years after 2009 – the date that EGTRRA sunsets – as part of this five-year holding Roth period. For most high-paid taxpayers that would mean leaving the rollover in the Roth IRA for an additional 5 years to obtain the full tax benefits of a Roth. This result is suggested in the preamble to the proposed regulations released in January 2006 on the taxation of Roth 401(k) distributions. A distribution from a Roth 401(k) account does not qualify as a tax-free distribution unless it satisfies both a “qualified purpose” and the five-year participation threshold. The preamble to the proposed distribution regulations addresses this issue under the heading “Determination of 5-Taxable-year Period after a Rollover to a Roth IRA.” The preamble states: “Section 402A (dealing with the Roth 401(k)) and section 408A (dealing with the Roth IRA) each provide for a 5-taxable-year period that must be completed in order for a distribution from a designated Roth account or a Roth IRA to be a qualified distribution. However, each of these sections contains different rules for determining when the 5-taxable-year requirement is satisfied. Generally, under section 402A, satisfaction of the 5-taxable-year requirement with respect to a designated Roth account under a plan is based on the years since a designated Roth contribution was first made by the employee under that plan. In contrast, the 5-year period under section 408A begins with the first taxable year for which a contribution is made to any Roth IRA. The IRS commentators suggested that, if a distribution from a designated Roth account to an individual is rolled into a Roth IRA, the individual receive credit under the 5-year rule in section 408A for the years since the individual first made a contribution to a designated Roth account. The IRS and Treasury Department do not believe that the Code permits this interaction between the two 5-year rules. Instead, these proposed regulations would provide that the 5-taxable-year period described in section 402A and the 5-taxable-year period described in section 408A(d)(2)(B) are determined independently. Thus, in the case of a rollover of a distribution from a designated Roth account maintained under a section 401(k) or 403(b) plan to a Roth IRA, the period that the rolled-over funds were in the designated Roth account does not count towards the 5-taxable-year period for determining qualified distributions from the Roth IRA. However, if an individual had established a Roth IRA in a prior year, the 5-year period for determining qualified distributions from a Roth IRA that began as a result of that earlier Roth IRA contribution applies to any distributions from the Roth IRA (including a distribution of an amount attributable to a rollover contribution from a designated Roth account).” The proposed regulations reflect a requirement in IRC § 402A that the five-taxable-year period begins on the first day of the taxable year in which the employee first contributes to the plan (the start year of the "5-year clock") and ends after the passage of five consecutive taxable years in which the plan is a Roth 401(k). Apparently, the year 2010, the year after the sunset of EGTRRA, is not such a year. As noted above, in some cases a 9-year requirement may apply. If the Roth provisions of EGTRRA are not extended for at least a year, then you will need to transfer a 401(k) distribution consisting of a Roth account to a Roth IRA in order to satisfy the five-year requirement. The proposed regulations set a separate five-year requirement for Roth IRAs and Roth 401(k)s. That is, you cannot tack on one year in the Roth IRA to the four years of a Roth 401(k) (2006 to 2009) to satisfy the five-year rule. The rollover would have to be held in a Roth IRA that itself meets the five-year requirement. Additionally, a salary deferral or Roth account cannot be distributed from a 401(k) plan unless the participant satisfies one of the plan’s eligible distribution events (e.g., 59 1/2, termination of employment). Thus, a highly compensated individual who is not eligible to make a Roth IRA contribution would not be able to begin the holding period in his or her Roth IRA until the calendar year of the Roth rollover. That could delay receiving a tax-free withdrawal from a Roth IRA until five years after retirement. In addition, here is one final twist: even if EGTRRA is extended and a Roth 401(k) distribution fully satisfies the five-year participation requirement, a separate five-year requirement must be met before the earnings of the rollover can be withdrawn tax-free. That is, the investment earnings on a Roth 401(k) that is rolled to a Roth IRA cannot be withdrawn tax-free until the Roth IRA satisfies a separate five-year requirement. This may not be a significant problem for most individuals because of the “ordering rule” that applies to the taxation of withdrawals from Roth IRAs under IRC § 408A(d). The taxation of a distribution from a Roth IRA is calculated on a "first-in, first-out" basis. Therefore, if the Roth 401(k) distribution met the 5-year requirement, then the full amount of the rollover may be withdrawn tax-free before any of the distribution is attributed to the earnings on the rollover. Gregory E. Matthews, CPA, Matthews Benefit Group, Inc. St. Petersburg, Florida gmat@eerisa.com

Tax benefits for Roth not fully settled

There is apparently a still open issue relating to qualifying for tax free distributions from a Roth 401(k). The issue arises if EGTRRA -- the 2001 pension reform legislation that, among other things, created Roth 401(k) accounts -- is not extended and relates to the question of whether a distribution from a Roth 401(k) may not meet the five-year requirement for a tax-free withdrawal. IRS speakers at the ABA Tax section meeting in San Diego commented that it may be necessary to roll a Roth 401(k) distribution to a Roth IRA before the amounts distributed qualify for tax free withdrawal. Apparently the IRS believes that you cannot count the calendar years after 2009 – the date that EGTRRA sunsets – as part of this five-year holding Roth period. For most high-paid taxpayers that would mean leaving the rollover in the Roth IRA for an additional 5 years to obtain the full tax benefits of a Roth.

This result is suggested in the preamble to the proposed regulations released in January 2006 on the taxation of Roth 401(k) distributions. A distribution from a Roth 401(k) account does not qualify as a tax-free distribution unless it satisfies both a “qualified purpose” and the five-year participation threshold. The preamble to the proposed distribution regulations addresses this issue under the heading “Determination of 5-Taxable-year Period after a Rollover to a Roth IRA.” The preamble states:

“Section 402A (dealing with the Roth 401(k)) and section 408A (dealing with the Roth IRA) each provide for a 5-taxable-year period that must be completed in order for a distribution from a designated Roth account or a Roth IRA to be a qualified distribution. However, each of these sections contains different rules for determining when the 5-taxable-year requirement is satisfied. Generally, under section 402A, satisfaction of the 5-taxable-year requirement with respect to a designated Roth account under a plan is based on the years since a designated Roth contribution was first made by the employee under that plan. In contrast, the 5-year period under section 408A begins with the first taxable year for which a contribution is made to any Roth IRA.

The IRS commentators suggested that, if a distribution from a designated Roth account to an individual is rolled into a Roth IRA, the individual receive credit under the 5-year rule in section 408A for the years since the individual first made a contribution to a designated Roth account. The IRS and Treasury Department do not believe that the Code permits this interaction between the two 5-year rules. Instead, these proposed regulations would provide that the 5-taxable-year period described in section 402A and the 5-taxable-year period described in section 408A(d)(2)(B) are determined independently. Thus, in the case of a rollover of a distribution from a designated Roth account maintained under a section 401(k) or 403(b) plan to a Roth IRA, the period that the rolled-over funds were in the designated Roth account does not count towards the 5-taxable-year period for determining qualified distributions from the Roth IRA. However, if an individual had established a Roth IRA in a prior year, the 5-year period for determining qualified distributions from a Roth IRA that began as a result of that earlier Roth IRA contribution applies to any distributions from the Roth IRA (including a distribution of an amount attributable to a rollover contribution from a designated Roth account).”

The proposed regulations reflect a requirement in IRC § 402A that the five-taxable-year period begins on the first day of the taxable year in which the employee first contributes to the plan (the start year of the "5-year clock") and ends after the passage of five consecutive taxable years in which the plan is a Roth 401(k). Apparently, the year 2010, the year after the sunset of EGTRRA, is not such a year.

As noted above, in some cases a 9-year requirement may apply. If the Roth provisions of EGTRRA are not extended for at least a year, then you will need to transfer a 401(k) distribution consisting of a Roth account to a Roth IRA in order to satisfy the five-year requirement. The proposed regulations set a separate five-year requirement for Roth IRAs and Roth 401(k)s. That is, you cannot tack on one year in the Roth IRA to the four years of a Roth 401(k) (2006 to 2009) to satisfy the five-year rule. The rollover would have to be held in a Roth IRA that itself meets the five-year requirement.

Additionally, a salary deferral or Roth account cannot be distributed from a 401(k) plan unless the participant satisfies one of the plan’s eligible distribution events (e.g., 59 1/2, termination of employment). Thus, a highly compensated individual who is not eligible to make a Roth IRA contribution would not be able to begin the holding period in his or her Roth IRA until the calendar year of the Roth rollover. That could delay receiving a tax-free withdrawal from a Roth IRA until five years after retirement.

In addition, here is one final twist: even if EGTRRA is extended and a Roth 401(k) distribution fully satisfies the five-year participation requirement, a separate five-year requirement must be met before the earnings of the rollover can be withdrawn tax-free. That is, the investment earnings on a Roth 401(k) that is rolled to a Roth IRA cannot be withdrawn tax-free until the Roth IRA satisfies a separate five-year requirement. This may not be a significant problem for most individuals because of the “ordering rule” that applies to the taxation of withdrawals from Roth IRAs under IRC § 408A(d). The taxation of a distribution from a Roth IRA is calculated on a "first-in, first-out" basis. Therefore, if the Roth 401(k) distribution met the 5-year requirement, then the full amount of the rollover may be withdrawn tax-free before any of the distribution is attributed to the earnings on the rollover.

Gregory E. Matthews, CPA,
Matthews Benefit Group, Inc.
St. Petersburg, Florida
gmat@eerisa.com