IRS Guide to Roth 401(k) Rollovers
Jan 07, 2014
As the name implies, the “Roth 401(k)” is a hybrid retirement plan that an employer can provide to its employees. This type of plan combines several elements of traditional 401(k) plans with Roth IRA features in designated accounts.
Now, the IRS has issued new guidance on rolling over funds from a traditional 401(k) account to a Roth account within the same plan (Notice 2013-74).
How a Roth 401(k) Works
As with a traditional 401(k) plan, an eligible employee can elect to defer part of his or her salary to a designated Roth account, subject to annual tax law limits. The employer may also choose to provide matching contributions up to a percentage of salary. For 2014, a participating employee can contribute up to $17,500 in elective deferrals, or up to $22,500 if he or she is age 50 or older.
In comparison, for 2014, contributions to a regular Roth IRA are limited to $5,000, or $6,500 if age 50 or over. Note: The ability to contribute to a Roth IRA is phased out for upper-income taxpayers, but there’s no such restriction for a Roth 401(k).
However, unlike a traditional 401(k), contributions to an employee’s account are made with after-tax dollars, instead of pre-tax dollars. Therefore, you forfeit a key tax benefit of 401(k)s. On the plus side, after an initial period of five years, “qualified distributions” are 100 percent exempt from federal income tax, just like qualified distributions from a Roth IRA. In contrast, regular 401(k) distributions are taxed at ordinary income rates, which can reach as high as 39.6 percent in 2014.
For this purpose, “qualified distributions” include distributions that are:
- Made after the participant has attained age 59 1/2;
- Made due to death or disability; or
- Used to pay for “first-time homebuyer expenses” (up to a lifetime limit of $10,000).
Therefore, you can take a qualified Roth 401(k) distribution in retirement after age 59 1/2 and pay zero tax, as opposed to the hefty tax bill that is often due with payouts from a traditional 401(k) plan. Furthermore, with a traditional 401(k), retirees must begin taking “required minimum distributions” (RMDs) after age 70 1/2. There’s no mandate to take lifetime RMDs with a Roth 401(k).
New Rules for In-Plan Rollovers
Under the American Taxpayer Relief Act of 2012 (ATRA), a 401(k) plan providing a designated Roth account can allow participants to transfer any amount “not otherwise distributable” under the plan to a designated Roth account. The transfer is treated as an in-plan Roth rollover. Furthermore, ATRA states that such a transfer does not violate the restrictions on distributions of employer contributions to a 401(k) plan for other tax purposes.
Keeping those basic rules in mind, here are some of the main points spelled out in the new IRS guidance on in-plan Roth 401(k) rollovers.
- A rollover to a designated Roth account within the same plan is available for elective deferrals in 401(k) plans, matching contributions and non-elective contributions, including qualified matching contributions and qualified non-elective contributions. Note: Similar rules apply to in-plan rollovers for comparable qualified plans, such as 403(b) plans used by not-for-profit organizations and 457 plans for employees of government agencies.
- The funds rolled over to an employee’s designated Roth account are subject to distribution restrictions in existence prior to the in-plan rollover. For example, distributions may not be allowed prior to age 59 1/2 for a traditional 401(k) plan, so that restriction may be applied to funds transferred to a Roth account.
- A rollover of an otherwise non-distributable amount is not subject to mandatory withholding nor does voluntary withholding apply. However, an employee making an in-plan Roth rollover may need to increase withholding or make estimated tax payments to avoid an underpayment penalty.
- A plan amendment permitting in-plan Roth rollovers of otherwise non-distributable amounts must be adopted by the last day of the first plan year in which this discretionary amendment is effective. To provide employers with more leeway to implement a change for a 2013 plan year, the deadline is extended to the latter of the last day of the first plan year in which the amendment is effective or December 31, 2014 (assuming the amendment is effective as of the date the plan first operates in accordance with the amendment).
- Employers with safe harbor plans are temporarily permitted to make a mid-year change to provide for in-plan Roth rollovers of otherwise non-distributable amounts. The temporary period allowed for changes ends on December 31, 2014.
- If an in-plan Roth rollover is the first contribution made to an employee’s designated Roth account, the five-year period of participation required for qualified distributions begins on the first day of the first tax year in which the employee makes the in-plan Roth rollover.
- In consideration of the non-discrimination requirements normally applicable to plan benefits, rights, and features — such as the right to make a rollover — a plan may restrict the type of contributions eligible for an in-plan Roth rollover and the frequency of in-plan Roth rollovers.
- Finally, if an employee rolls over funds into a designated Roth account and all or a portion of the rollover is later determined to be an excess deferral or excess contribution, the excess amount (plus applicable earnings) must be distributed from the designated Roth account, even if the amount was an otherwise non-distributable amount at the time of the in-plan Roth rollover.
These are just some of the highlights of the complex new rules. Don’t hesitate to seek assistance from your tax or employee benefits professional.