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On Jan. 25, 2006, the Treasury Department and the Internal Revenue Service (IRS) issued proposed regulations providing comprehensive guidance on the taxation of distributions from the designated Roth accounts maintained in ��401(k) and 403(b) plans. The Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) added �402A to the Internal Revenue Code of 1986, as amended (Code) which permits employees to designate all or a portion of their elective deferrals under a �401(k) plan or a �403(b) annuity plan as a Roth contribution. These contributions would receive tax treatment similar to a Roth IRA in that contributions would be made on an after-tax basis and “qualified distributions” from the designated Roth account would be excluded from gross income. These proposed regulations are the most recent in a string of regulations issued by the Treasury Department and the IRS in response to the passage of EGTRRA. The final regulations under Code �401(k) were issued on Dec. 29, 2004 and those regulations reserved �1.401(k)-1(f) for special rules for designated Roth contributions. Final regulations for that section were issued on Jan. 3, 2006. Those regulations, however, did not address the taxation of distributions from designated Roth accounts or the reporting requirements that apply to designated Roth contributions or distributions from the accounts. These proposed regulations provide guidance, in question and answer form, on these matters. In addition, the proposed regulations include rules for the rollover of distributions from designated Roth accounts to other eligible retirement plans. Finally, in addition to other conforming amendments, the proposed regulations provide guidance on Roth contributions to Code �403(b) plans by amending the proposed code regulations issued under �403(b) in 2004 to reflect the new Code �402A. RULES FOR QUALIFIED DISTRIBUTIONS Under the proposed regulations a distribution from a designated Roth account will not be included in gross income if it is a qualified distribution. A qualified distribution is a distribution made after a five-year period of participation and is made either after the participant’s attainment of age 59 and one-half, or upon the participant’s death or disability (as defined in Code �72(m)(7)). The five-year period begins on the first day of the employee’s taxable year in which the employee first makes a Roth contribution to the distributing plan and ends when five consecutive taxable years have been completed. The five-year period is determined separately for each plan in which an individual maintains a designated Roth account. However, in the case of a direct rollover from a designated Roth account to a designated Roth account in another plan (rollovers are discussed below), the five-year period begins when the employee first makes a contribution to the original plan. The proposed regulations provide that the five-year period is not redetermined for any portion of an employee’s designated Roth account. Thus, even if all or a portion of a designated Roth account is paid to an employee’s beneficiary following the employee’s death or to an alternate payee pursuant to a QDRO (a qualified domestic relations order, a device created by the Retirement Equity Act to permit separating a pension into two parts without violating the terms of the Employee Retirement Income Security Act), the five-year period is not redetermined. Similarly, if an employee receives a distribution of his or her entire designated Roth account and subsequently makes another contribution to the account, the five-year period is not redetermined. If a distribution is not a qualified distribution, a portion of the distribution will be excluded from gross income and a portion will be included. This is different from the taxation of nonqualified distributions from a Roth IRA. Under Code �408A(d), special ordering rules apply to distributions from Roth IRAs so that the first distributions from a Roth IRA are a return of contributions and no amount is includible in gross income until all contributions have been distributed. The IRS has rejected the request of commentators to apply this special ordering rule to designated Roth accounts stating that under Code �402A a designated Roth account is treated as a separate contract under Code �72. Therefore, the taxation is determined under �72(e)(8) of the code, which provides for a portion of the distribution to be excluded from gross income based on the ratio of the amount “invested in the contract” to the total account balance at the time of distribution. As an example, if a participant has contributed $20,000 to a designated Roth account and takes a distribution of $5,000 at a time when the account balance is $25,000, $4,000 of the distribution ($5,000 times ($20,000/$25,000)) is treated as a nontaxable return of the investment in the contract and $1,000 is treated as includible earnings on the contract. ROLLOVERS Code �402A(c)(3) provides that a rollover of a designated Roth account distribution may only be made to the extent otherwise allowable, and the rules in Code �402(c)(2) relating to the distribution of an amount not includible in gross income apply to a distribution from a designated Roth account. Therefore, in order to roll over an entire distribution from a designated Roth account in one plan to a designated Roth account in another plan, the rollover must be accomplished through a direct rollover and can only be made to a plan qualified under Code �401(a) which agrees to separately account for the amount not includible in income. If a distribution from a designated Roth account is made to the employee, the taxable portion may still be rolled over to a designated Roth account in a Code �401(k) or 403(b) plan within 60 days but the employee’s period of participation in the distributing plan will not be carried over to the recipient plan for purposes of calculating the five-year period in the recipient plan. All or any portion of a distribution which is made to the employee also may be rolled over into a Roth IRA within 60 days. If only a portion of the distribution is rolled over to a Roth IRA, the portion that is not rolled over is treated as first consisting of the amount of the distribution that is includible in gross income. For this purpose, the income limit for contributions to Roth IRAs will not apply. However, the five-year period described in Code �402A relating to the distributing designated Roth account, and the five-year period described in Code �408A(d)(2)(B) applicable to the Roth IRA are determined independently. As a consequence, the individual’s period of participation under the distributing plan is not carried over to the individual’s Roth IRA for purposes of determining the five-year requirement under the Roth IRA. Rather, the five-year period applicable to the Roth IRA will commence upon the contribution of the rollover amount, unless the individual had previously established the Roth IRA, in which case it will have commenced at the time of the initial contribution to the Roth IRA. The proposed regulations state that if a nonqualified distribution from a designated Roth account is rolled over into a Roth IRA, the portion of the distribution from the designated Roth account that constitutes a nontaxable return of investment in the contract will be treated as basis in the Roth IRA. If the distribution, however, is a qualified distribution, the entire amount of the distribution will be treated as basis in the Roth IRA and, when subsequently distributed, will be entirely excludible from gross income regardless of whether the five-year period applicable to the Roth IRA has been satisfied. The investment return earned on that distribution while in the Roth IRA, however, will not be excluded from income unless the distribution satisfies the requirements for a qualified distribution from the Roth IRA. Distributions from a Roth IRA may not be rolled over to a designated Roth account. REPORTING, RECORDKEEPING Under the proposed regulations, the plan administrator or other responsible party with respect to a plan with a designated Roth account would be responsible for keeping track of the five-year period for each employee, as well as the amount of designated Roth contributions made on behalf of each employee. In addition, if a distribution from a designated Roth account is directly rolled over to a designated Roth account of another plan, the administrator of the distributing plan must provide the recipient plan’s administrator with a statement indicating the first day of the five-year period and the amount of the distribution attributable to basis. If the distribution is a qualified distribution, the statement need only indicate that the distribution is a qualified distribution. If the distribution is made directly to the employee, the same information must be provided to the employee upon request but the first year of the five-year period need not be included as the proposed regulations provide the participation in the distributing plan will not be carried over to the recipient plan if the distribution is made to the employee. These statements would be required to be made within 30 days of the distribution (or request by the employee) and the administrator of the recipient plan would be permitted to rely on these statements. Although the reporting requirements are proposed to be effective beginning with the 2007 taxable year, it will not be possible to comply with Code �402A’s separate accounting requirement without keeping track of each employee’s investment in the contract under the designated Roth account from the time the first contribution is made. Furthermore, if a rollover is made from a designated Roth account to another designated Roth account during 2006, the recipient plan will, in all likelihood, request information from the distributing plan sufficient to determine when the five-year period commenced and how much was contributed to the account. Thus, plan administrators and other plan record keepers are well-advised to maintain this information beginning with the establishment of a designated Roth account. In addition, the IRS must be notified if a portion of a distribution is includible in income (determined without regard to the rollover) and any portion of the distribution is then rolled over to a designated Roth account by the distributee rather than by a direct rollover. In its notification to the IRS, the recipient plan’s administrator must include: (1) the employee’s name and Social Security number, (2) the amount rolled over, (3) the year in which the rollover contribution was made and (4) any other information the commissioner requires in future published guidance. SEPARATE ACCOUNTING Pursuant to Code �402A, a designated Roth account is a separate account under a Code �401(k) or �403(b) plan to which designated Roth contributions are made and separate accounting is maintained. The proposed regulations provide that any transaction or accounting methodology involving an employee’s designated Roth account and any other accounts under the plan or plans of an employer that has the effect of directly or indirectly transferring value from another account into the designated Roth account violates this separate accounting requirement. Any transaction, however, that merely exchanges investments between accounts at fair market value will not violate the separate accounting requirement. EXCESS DEFERRALS Although designated Roth contributions are not excluded from income when contributed, they are treated as elective deferrals for the limits imposed by Code �402(g). Amounts contributed which exceed the Code �402(g) limitations may be distributed by April 15 of the year following the year of excess without any adverse tax consequences. The proposed regulations provide that any distribution of excess deferrals from a designated Roth account after April 15 will be includible in income without any exclusion for basis under �72 and will not be eligible to be rolled over. Should any excess deferrals remain in the account past the April 15 deadline, those amounts will be the first amounts distributed from the designated Roth account until the full amount of the excess deferrals and attributable earnings are distributed. The proposed regulations also conform the gap period income rules for a distribution of excess deferrals under Code �402(g) to the gap period income rules in the 2004 final Code ��401(k) and 401(m) regulations. Under these rules, income from the period after the taxable year must to be included in the distribution to the extent the employee is or would be credited with allocable gain or loss on those excess deferrals for that period, if the total account were to be distributed. This gap period income rule applies to both pre-tax excess deferrals and designated Roth contributions. UNDER �403(b) PLANS The proposed regulations generally incorporate the rules for a Code �401(k) designated Roth account into the rules for Code �403(b) plans. Unlike Code �401(k), however, Code �403(b) plans include a universal availability requirement as described in Code �403(b)(12)(A)(ii). This requirement ensures that if one employee in the organization is permitted to make an elective deferral than every employee must be permitted to make such a deferral. The proposed regulations state that this universal availability requirement will also apply to Roth contributions. CONCLUSION Although Code �402A applies to taxable years beginning on or after Jan. 1, 2006, the majority of the proposed regulations under that statute will not take effect until Jan. 1, 2007. However, the rules pertaining to the separate accounting requirements, rollovers and excess deferrals will be effective on Jan. 1, 2006. Until the regulations are finalized, taxpayers may rely on the proposed regulations. If any future guidance is more restrictive than that provided in the proposed regulations, it will only be applied prospectively. Donald P. Carleen is a partner and chairs the executive compensation and employee benefits group at Fried, Frank, Harris, Shriver & Jacobson. Matthew Behrens, an associate with the firm, assisted in the preparation of this article.

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