Tag Archive for: Designated Roth

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Roth IRAs v. Designated Roth 401(k)s

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“What are the differences between Roth IRAs and designated Roth 401(k) accounts?”

Highlights of discussion

While there are many differences, the following chart summarizes some of the key dissimilarities.

Feature Roth IRA Designated Roth 401(k) account
Investment options Generally, unlimited, except for life insurance and certain collectibles As specified by the plan
Eligibility for contribution  Must have earned income under $144,000 if a single tax filer or under $214,000 if married filing a joint tax return ·   Access to a 401(k), 403(b) or governmental 457(b) plan with a designated Roth contribution option and

·   The individual must meet eligibility requirements as specified by the plan
Contribution limit (2022) $6,000 ($7,000 if age 50 or older) $20,500 ($27,000 if age 50 or older)
Conversions Anyone with eligible IRA or employer-plan assets may convert them to a Roth IRA Plan permitting, anyone with eligible plan assets may convert them within the plan to a designated Roth account
Recharacterize contribution Yes, within prescribed period No
Required minimum distributions Not during owner’s lifetime Yes
Tax- and penalty-free qualified distributions, regardless of type of money Taken

·      After owning the Roth IRA for five years and

·      Age 59 ½, death, disability, or for first home purchase

 Must have a distribution–triggering event under plan terms, plus

·   Five years after owning the designated Roth account and

·   Age 59 ½, death, or disability
Tax and/or penalty on nonqualified distributions based on type of money According to IRS distribution ordering rules:

1.     Contributions: Always tax- and penalty-free

2.     Taxable Conversions: On a first-in, first-out basis by year; always tax-free; penalty if taken within five years of conversion

3.     Nontaxable conversions:  On a first-in, first-out basis by year; always tax- and penalty-free

4.     Earnings: Taxed as ordinary income, subject to penalty unless exception applies

 Withdrawals represent a pro-rata return of contributions and earnings in the account; earnings are taxable and subject to penalty unless an exception applies. See IRS Notice 2010-84 for rules applicable to the return of designated Roth 401(k) converted amounts
Timing of distributions At any time, subject to tax and/or penalty depending on type of assets distributed Following plan-defined, distribution triggering events
Loans No Yes, if plan permits
Five-year holding period for qualified distributions Begins January 1 of the year a contribution or conversion is made to any Roth IRA of the owner ·         Separate for each 401(k) plan in which an individual participates

·         Begins January 1 of the year a contribution or in-plan conversion is made to the account
 Beneficiary Anyone, but spousal consent required in community property states Anyone, but spousal consent required

 

Conclusion

While both Roth IRAs and designated Roth 401(k) plan contributions offer the potential for tax-free withdrawals, there are several key differences between the two arrangements. Whether one, the other or both may be right for a particular investor depends on the individual’s circumstances and goals and should be determined based on a thorough conversation between the investor and his or her tax advisor.

 

 

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Designated Roth 401(k) Contributions and IRS Form 8606

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“My client made designated Roth 401(k) contributions in 2021. Because these contributions are made on an after-tax or nondeductible basis, does that mean he must file IRS Form 8606 to report them?”

ERISA consultants at the Retirement Learning Center (RLC) Resource Desk regularly receive calls from financial advisors on a broad array of technical topics related to IRAs, qualified retirement plans and other types of retirement savings and income plans, including nonqualified plans, stock options, and Social Security and Medicare.  We bring Case of the Week to you to highlight the most relevant topics affecting your business.

A recent call with an advisor in Tennessee is representative of a common question related to designated Roth 401(k) contributions.

Highlights of Discussion

  • When dealing with tax-related questions, always seek the guidance of a tax professional. What follows is general information based on IRS tax forms.
  • No, designated Roth contributions made to a 401(k) plan are not reported on IRS Form 8606, Nondeductible IRAs (see the instructions for Form 8606). The 401(k) [or 403(b) or governmental 457(b)] plan administrator reports such contributions on a worker’s IRS Form W-2, Wage and Tax Statement in box 12. Because designated Roth 401(k) contributions are subject to federal income tax withholding and Social Security and Medicare taxes (and railroad retirement taxes, if applicable), they also must be included in boxes 1, 3, and 5 (or box 14 if railroad retirement taxes apply) on Form W-2.
  • Please note that where designated Roth 401(k) contributions might show up on Form 8606 is on Line 22, which is used to report the basis in a Roth IRA. Any designated Roth 401(k) amounts an individual rolls into his Roth IRA during the year would be included as basis in the Roth IRA and included in the figure reported on Line 22.

Conclusion

Designated Roth contributions made to a 401(k) plan are not reported on IRS Form 8606, Nondeductible IRAs. However, a taxpayer will need to include designated Roth 401(k) amounts rolled into a Roth IRA in the value of the Roth IRA’s basis.

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Designated Roth Account Rollover and Five-Year Rule

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“My client participates in a 401(k) plan, has a Designated Roth account and wants to roll over the Designated Roth account to a Roth IRA. Can my client count the time in the 401(k) plan towards the five-year waiting period for the Roth IRA needed for taking qualified distributions?”

ERISA consultants at the Retirement Learning Center Resource Desk regularly receive calls from financial advisors on a broad array of technical topics related to IRAs, qualified retirement plans and other types of retirement savings and income plans, including nonqualified plans, stock options, and Social Security and Medicare. We bring Case of the Week to you to highlight the most relevant topics affecting your business.

A recent call with an advisor in Pennsylvania is representative of a common inquiry regarding Designated Roth contributions in a 401(k) plan.

Highlights of Discussion
The short answer is, surprisingly, “No.” If your client rolls over his or her 401(k) plan Designated Roth account assets to a Roth IRA, the time spent in the Designated Roth account will not carry over to the Roth IRA (IRS Treasury Regulation § 1.408A–10, Q&A 4).

That means, if your client established his or her first Roth IRA with the rollover of Designated Roth account assets, the five-year period for determining qualified distributions from the Roth IRA would begin that year. In essence, the five-year period for determining qualified distributions in the 401(k) plan is determined separately from the five-year period for determining qualified distributions in the Roth IRA.

It’s another one of those “earlier of” scenarios for the Roth IRA and the five-year period §1.408A–6, Q&A 2. The five-year period for the Roth IRA begins with the earlier of the taxable year in which

• The first Roth IRA contribution (or conversion) is made to any Roth IRA owned by the individual, or
• A rollover contribution of a Designated Roth account is made to a Roth IRA.

Conclusion
The five-year period for determining qualified distributions from a 401(k) plan Designated Roth account is determined separately from the five-year period for determining qualified distributions in a Roth IRA. For that reason, it may be advantageous for investors to make a Roth IRA contribution sooner rather than later in order to put the five-year clock in motion in the Roth IRA.

 

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Oops … How to fix switched contributions

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“My client initially elected to make designated Roth contributions to her 401(k) plan and a few years later switched her election to pre-tax elective deferrals. We just discovered the employer is still treating her deferrals as designated Roth contributions. Is there a way to retroactively treat these amounts as pre-tax salary deferrals?”

ERISA consultants at the Retirement Learning Center (RLC) Resource Desk regularly receive calls from financial advisors on a broad array of technical topics related to IRAs, qualified retirement plans and other types of retirement savings and income plans, including nonqualified plans, stock options, and Social Security and Medicare. We bring Case of the Week to you to highlight the most relevant topics affecting your business.

A recent call with a financial advisor from Massachusetts is representative of a common inquiry related to designated Roth contributions in 401(k) plans.

Highlights of the Discussion

Yes, there is a way of correcting the situation where an employer has failed to make the correct type of salary deferral to a 401(k) plan (i.e., pre-tax/designated Roth, or vice versa) based on the participant’s deferral election. It will require some correcting of IRS tax forms and the employer’s participation in the IRS’s Employee Plans Compliance Resolution System (EPCRS) program. Please refer to Fixing Common Mistakes-Correcting a Roth Contribution Failure and Revenue Procedure 2019-19.  

Generally speaking, an employer in this situation can correct the error by executing three steps.

Step 1: Transfer deferrals

The employer transfers the erroneously deposited deferrals, adjusted for earnings, from the designated Roth account to the pre-tax salary deferral account. The employer must ensure the information on IRS Form W-2, Wage and Tax Statement, for the participant is correct (i.e., reflecting the correct contribution type). That may involve the employer filing a corrected Form W-2 with the IRS showing the previously misidentified designated Roth contributions as pre-tax salary deferrals.

Step 2: Follow EPCRS or Audit CAP

Since the error represents an operational failure on the plan sponsor’s part, the sponsor should follow plan correction procedures outlined in the IRS’s EPCRS program. Depending on the circumstances, it may be possible for the employer to self-correct the error, without penalty or a formal filing with the IRS. Otherwise, a sponsor can file with the IRS under the IRS’s Voluntary Correction Program (VCP). If the error was discovered during an IRS audit, the only corrective option is to follow the Audit Closing Agreement Program (Audit CAP).

Step 3: Establish avoidance procedures

Part of correcting a plan error is to ensure that the error will not happen again. Plan sponsors should create, document and follow new policies and procedures that will prevent future failures such as these.

Conclusion

The IRS has identified the misclassification of employee salary deferrals as designated Roth contributions and vice versa by plan sponsors as a common plan mistake. Fortunately, there is a relatively painless IRS process to remedy the situation.

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Roth 401(k)s and the Five-Year Clock

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“Can you explain how the ‘five-year clock’ applies to Roth 401(k) contributions?”

ERISA consultants at the Retirement Learning Center (RLC) Resource Desk regularly receive calls from financial advisors on a broad array of technical topics related to IRAs, qualified retirement plans and other types of retirement savings and income plans, including nonqualified plans, stock options, and Social Security and Medicare. We bring Case of the Week to you to highlight the most relevant topics affecting your business.

A recent call with a financial advisor from New York is representative of a common inquiry related to designated Roth contributions in a 401(k) plan.

Highlights of the Discussion

Distributions of Roth 401(k) contributions (i.e., designated Roth contributions) can be taken tax and penalty free if the participant meets certain conditions for a “qualifying distribution.” A qualifying distribution is one that is made after a five-taxable-year period of participation (“the five-year clock”), and the participant has attained age 59 ½, has become disabled, or in the case of a beneficiary, following the participant’s death.

The five-year clock begins on the first day of the participant’s taxable year in which he or she first makes designated Roth contributions to the plan. If the first Roth contribution is a rollover of designated Roth contributions from another 401(k) plan, the starting of the five-year clock depends on whether the rollover is direct or indirect.

If the participant completes a direct rollover from a designated Roth account under another 401(k) plan, the five-year period is deemed to have begun on the first day of the taxable year that the employee made Roth 401(k) contributions to the other plan. In contrast, an indirect rollover contribution restarts the five-year clock under the receiving plan for a participant who has made no prior Roth 401(k) contributions to the receiving plan (Treasury Regulation 1.402A-1, Q&A 4).

Conclusion

Since the five-year clock for determining a tax-free, qualifying distribution of Roth 401(k) contributions begins on the first day of the participant’s taxable year in which he or she first makes a designated Roth contribution to the plan, it may be wise for a participant—if he or she has the option—to designate even $1 of elective contributions as a Roth 401(k) contribution right away in order to start the ticking of the five-year clock. And if a participant is rolling over Roth 401(k) contributions—a direct rollover is the only way to avoid restarting the five-year period.

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Federal Withholding on an In-Plan Roth Conversion

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“How do the federal withholding rules apply to an in-plan Roth conversion in a 401(k) plan?”

ERISA consultants at the Retirement Learning Center Resource Desk regularly receive calls from financial advisors on a broad array of technical topics related to IRAs and qualified retirement plans. We bring Case of the Week to you to highlight the most relevant topics affecting your business.

Highlights of Discussion

  • The federal withholding rules for in-plan conversions to a designated Roth account in a 401(k) plan are similar to the rules that generally apply for eligible rollover distributions that are rolled over directly to another eligible plan versus rolled over indirectly (i.e., within 60 days) (Internal Revenue Code Section 3405). The IRS has provided specific guidance for in-plan Roth conversions in Notice 2013-74 Q&A 4.
  • If the conversion of assets in-plan is done as a direct rollover to the designated Roth account, and the participant does not receive any of the assets, the plan sponsor should not withhold taxes. Neither can a participant request voluntary withholding under IRC Sec. 3402(p). Since a conversion is generally a taxable event, a plan participant making a direct in-plan Roth conversion may need to increase his or her withholding or make estimated tax payments to avoid an underpayment penalty from the IRS.
  • In contrast, if a plan participant receives a distribution in cash from the plan, the plan sponsor must withhold 20 percent federal income tax even if the participant later rolls over the distribution to a designated Roth account within 60 days. Because plan sponsors do not apply federal income tax withholding to a direct in-plan Roth conversion, a plan participant may need to increase his or her withholding or make estimated tax payments to avoid an underpayment penalty from the IRS.

Conclusion

Because plan sponsors do not apply federal income tax withholding to a direct in-plan Roth conversion, a plan participant may need to increase his or her withholding or make estimated tax payments to avoid an underpayment penalty from the IRS.

 

 

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