Roth 401(k) Contributions
One provision of the Economic Growth and Tax Relief Reconciliation Act of 2001 ("EGTRRA") that had a delayed implementation date is the provision for Roth 401(k) contributions. (Technically, Roth contributions may be made to 403(b) annuity plans as well. In the remainder of this Alert, however, we will refer only to the far more widespread 401(k) plans.) The Internal Revenue Service ("IRS") recently issued proposed regulations addressing Roth 401(k) contributions, which are scheduled to become effective January 1, 2006, for calendar year plans.
A Roth 401(k) contribution is an after-tax elective contribution made by a participant to a 401(k) plan. The participant may irrevocably designate part or all of such 401(k) elective contribution as a taxable Roth 401(k) contribution. The employee will be taxed on the Roth 401(k) contribution in the year the elective deferral is made. The Roth 401(k) contribution grows tax-free in the plan and, together with earnings, will be tax-free when distributed to the participant as a qualified distribution. Unlike Roth IRAs, there is no maximum income limit with respect to the persons eligible to make Roth 401(k) contributions.
Under Section 402A of the Internal Revenue Code (the "Code") and the proposed regulations, Roth 401(k) contributions generally are treated in the same manner (except for the tax treatment for the individual contributor) as traditional 401(k) elective contributions. They are fully vested and are counted toward the annual limit on elective deferrals ($15,000 in 2006). They may be matched by the employer in the same manner as traditional 401(k) contributions and are subject to the ADP test that is used to test traditional 401(k) contributions for discrimination. Roth 401(k) contributions are subject to the same distribution events as 401(k) contributions (termination of employment, death, disability, age 59½, hardship) and are subject to the age 70½ minimum required distribution rules.
However, Roth 401(k) contributions are subject to additional distribution restrictions in order to qualify the earnings on the distribution as tax-free. Accumulated Roth 401(k) contributions must be paid after age 59½ or upon death or disability and may not be paid during the five years following the first Roth 401(k) contribution to the plan or to a predecessor Roth 401(k) plan (for rolled over Roth amounts). Furthermore, unlike a Roth IRA, distributions of Roth 401(k) contributions for a first time home purchase will not be a qualified distribution.
Roth 401(k) contributions must be separately accounted for under the 401(k) plan. Moreover, the plan must be amended to permit Roth 401(k) contributions.
If a company is considering incorporating Roth 401(k) contributions as part of its 401(k) plan, now is not too early to contact the administrator of the plan to determine the feasibility (including cost) of adding provisions for Roth 401(k) contributions. A company should allow sufficient time for participant education and elections, since the choice between before-tax and after-tax contributions may not be a simple one; a participant will need to consider, among other factors, present and future tax rates and the length of time from contribution to expected payment.
Comparison Traditional 401(k) and Roth 401(k)
1. Traditional and Roth 401(k) contributions are subject to the same $15,000 limit in 2006. In other words, the sum of a participant’s traditional 401(k) contributions and Roth 401(k) contributions may not exceed $15,000 for 2006.
2. The amounts are available for loans if the plan so permits.
3. Distributions of amounts equal to after-tax Roth 401(k) contributions will be non-taxable. In order for earnings on such contributions to be non-taxable, the distribution must be a qualified distribution, which means that it must be made as a result of death, disability, or attaining age 59½ and may not be made prior to five years following the earlier of the first year in which the participant made a designated Roth 401(k) contribution to the plan or, if the Roth 401(k) contribution is a rollover amount, the first year for which the participant made a Roth 401(k) contribution to the previous plan.
Extension of "Use it or Lose it" Period for Reimbursement Accounts
The IRS recently announced in Notice 2005-42 an extension of the "use it or lose it" period that applies to health care and dependent care reimbursement accounts under cafeteria plans. Cafeteria plans also are referred to as flex plans, flexible benefit plans and Section 125 plans.
Under prior guidance, any unused amounts held in a reimbursement account at the end of the plan year was forfeited, and the employee lost the right to be reimbursed from the forfeited amounts. Notice 2005-42 creates a grace period that changes the effective date of the forfeiture from the last day of the plan year to the 15th day of the third month following the end of the plan year. For calendar year reimbursement plans, this means that employees will be able to use amounts remaining in their reimbursement account on December 31 to receive reimbursement for expenses incurred through March 15 of the next year.
As an example, assume a participant with a health care reimbursement account has $200 remaining in that account on December 31. That $200 can be carried over and used to reimburse the participant for health expenses incurred between January 1 and March 15 of the next year. If any amount remains from the carried over $200 on March 15, then that remaining amount will be forfeited.
Other forfeiture and operational rules for reimbursement plans remain unchanged. For example, amounts under a health care reimbursement plan may not be cashed out or used to pay benefits for dependent care, or vice versa . As under current guidance, a period after March 15—for example, 60 or 90 days—may be provided during which the participants may submit their reimbursement requests for expenses incurred up to March 15.
Your plan documents must be amended if you wish to permit the extended grace period. This change in the "use it or lose it" date is effective beginning with the 2005 plan year. If you want to adopt the change for the 2005 year, your plan documents must be amended on or before December 31, 2005 (or the last day of the relevant plan year for non-calendar year plans) in order to permit the extension.
If you are considering amending your plan to adopt the grace period effective for the 2005 plan year, and if you use an outside record keeper to administer your reimbursement plans, we urge you to coordinate as soon as possible with your record keeper. The extension of the forfeiture date will require record keepers to make system changes that may be difficult to complete for 2005 implementation. As a result of these difficulties, some record keepers, if they allow the change for 2005, are considering charging a premium or surcharge to their clients who want to make the change effective for 2005.
Automatic Rollover of Mandatory Distributions
We previously issued an Alert on the automatic rollover to an IRA of small account and other mandatory distributions for which the participant does not provide distribution instructions.
This is a reminder that the amendment to incorporate the automatic rollover rules, or the amendment to avoid the automatic rollover rules by changing your plan’s mandatory distribution provisions, must be adopted by the last day of the first plan year that ends on or after March 28, 2005. For calendar year plans, that date would be December 31, 2005. However, if your plan operates on a fiscal year, you may need to adopt the amendment sooner. In all situations, you must operate your plan, effective March 28, 2005, in accordance with the amendment that you have adopted, or that you intend to adopt.
Bankruptcy Protection for IRAs
Close on the heels of the U.S. Supreme Court’s April 4, 2005 decision in Rousey v. Jacoway, 125 S.Ct. 1561 (2005), the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (the "Act") was signed by President Bush on April 20, 2005. While the Rousey case gave bankruptcy protection to IRAs as long as the amounts in question were reasonably necessary for support of the debtor and his or her dependents, the Act gives IRAs a complete exemption from creditor claims in bankruptcy, subject only to a $1 million limit for contributory (as opposed to rollover) IRAs. The Act thus levels the bankruptcy playing field for all manner of tax-qualified plans, IRAs and deferred compensation plans of both governmental and tax-exempt entities. Previous federal bankruptcy protection had covered only stock bonus, pension, profit-sharing, annuity and similar plans.
Because of the differences among state bankruptcy protections for IRAs, qualified plan participants were often reluctant to request rollovers to IRAs. Full bankruptcy protection for qualified plan accounts might be lost for those same amounts in a rollover IRA. Starting October 17, 2005, the effective date of the Act, such rollovers to IRAs will be shielded from creditors in bankruptcy. The only limit on bankruptcy protection will be the $1 million cap for contributory IRAs; however, such an accumulation will be the product of robust investment returns on annual contributions of less than $5,000, an unlikely scenario for bankruptcy.
Circular 230 Disclaimer
The following disclaimer is provided in accordance with the Internal Revenue Service’s Circular 230 (21 CFR Part 10). Any tax advice contained in this Alert (including any attachments) is intended to be preliminary, for discussion purposes only, and not final. Any such advice is not intended to be used, and cannot be used by any person, for marketing, promoting or recommending any transaction or for the use of any person in connection with the preparation of any tax return. Accordingly, this advice is not intended or written to be used, and it cannot be used, by any person for the purpose of avoiding tax penalties that may be imposed on such person. All taxpayers should seek advice based on their own particular circumstances from their independent tax advisor.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.