Current developments.

• Author: Walker, Deborah
• Position: Part 2 - Qualified retirement plans and welfare benefits

EXECUTIVE SUMMARY

* The IRS issued final regulations on Sec. 401(k) designated Roth contributions and proposed regulations on distributions from Roth 401(k) accounts.

* Rev. Proc. 2006-27 revised some of the EPCRS principles and added several new remedies for common plan qualification failures.

* Congress clarified the definition of a dependent and the IRS issued guidance on leave-sharing plans.

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This two-part article covers the most significant developments in compensation and employee benefits over the past year (from August 2005 to August 2006). Part I, in the January 2007 issue, focused on compensation developments. Part II, below, covers fringe benefits and qualified plans.

Qualified Plans

Roth 401(k) Final Regs.

On Dec. 30, 2005, the IRS issued final regulations (13) on permitting Sec. 401(k) plan participants to make designated Roth contributions to separate Roth accounts within their plans. The final regulations--which were effective Jan. 3, 2006, and apply to plan years beginning after 2005--give plan sponsors much of the information they need to begin offering a Roth 401(k) option.

The regulations require employees to designate elective deferrals as Roth contributions "at the time of the cash or deferred election" Once made, the designation must be irrevocable. However, employees can change or revoke the designation when making future elections.

Under the final regulations, the rules on the frequency of elections to make pretax elective contributions also apply to elections to make designated Roth contributions. Thus, an employee must have an effective opportunity to make (or change) an election to make designated Roth contributions at least once per plan year.

Designated Roth contributions must be in lieu of all or a portion of the pretax elective contributions the participant is otherwise eligible to make under the plan. Thus, according to the preamble, a Sec. 401(k) plan must offer pretax elective contributions to provide for designated Roth contributions. This means employers may not offer Sec. 401(k) plans that accept only designated Roth contributions.

The final regulations clarify that plans may use automatic enrollment in conjunction with designated Roth contributions. Plans that take advantage of this must specify the extent to which default contributions are pretax elective contributions or designated Roth contributions. If the default contributions are designated Roth contributions, the automatic enrollee is deemed to have irrevocably designated the contributions as Roth contributions.

Plans that permit designated Roth contributions must establish separate accounts (designated Roth accounts) for each employee making such contributions, and maintain separate recordkeeping for each account. This separate accounting requirement begins when the designated Roth contribution is contributed and continues until all assets in such account have been distributed.

The regulations require plans to maintain a record of each employee's investment in the contract (i.e., designated Roth contributions that have not been distributed), and to allocate gains, losses and other credits or charges to each employee's designated Roth account (and other plan accounts) on "a reasonable and consistent basis." Neither matching contributions nor forfeitures may be allocated to designated Roth accounts.

Designated Roth contributions are subject to the same requirements as other elective deferrals to Sec. 401(k) plans, except they are taxable. Accordingly, the regulations specify that designated Roth contributions are immediately nonforfeitable and subject to the Sec. 401(k)(2)(B) restrictions on distributions. Similarly, designated Roth contributions may be treated as catch-up contributions and serve as the basis for a participant loan.

The regulations also subject designated Roth contributions to the Sec. 401(a)(9) required minimum distribution (RMD) rules. This is noteworthy, because the RMD rules generally do not apply to Roth IRAs. Designated Roth contributions rolled over to a Roth IRA would not continue to be subject to the RMD rules.

The regulations further provide that designated Roth contributions are elective contributions for purposes of the actual deferral percentage (ADP) test. For a plan that uses corrective distributions of excess contributions to cure a failed ADP test, the regulations permit plans to allow highly compensated employees to elect whether excess contributions are attributable to designated Roth contributions or to pretax elective deferrals. Any corrective distributions of excess contributions attributable to designated Roth contributions are not taxable, but the income attributable to such contributions is subject to tax. (Similar rules apply for using corrective distributions to cure actual contribution percentage testing failures.)

Prop. Regs. on Roth 401(k) Distributions

The IRS issued proposed regulations (14) on the tax treatment of distributions from Roth 401(k) accounts on Jan. 26, 2006. The proposed regulations deal with most questions relating to distributions from Roth 401(k) accounts, including questions about plan administrators' reporting requirements for such distributions.

Only qualified distributions from Roth 401 (k) accounts are eligible for tax-preferred treatment. A qualified distribution is one that occurs after a five-year period of participation and that either is (1) made on or after the date the employee attains age 59 1/2, (2) made after the employee's death or (3) attributable to the employee being disabled.

Under the proposed regulations, this five-year period would begin on the first day of the employee's tax year for which the employee first made designated Roth contributions to the plan and end at the completion of five consecutive tax years. The five-year period is plan-specific, so an individual making designated Roth contributions to more than one Roth 401(k) plan generally must satisfy the five-year period for each plan. However, in the case of a direct rollover from one Roth 401 (k) plan to another, the five-year period of participation for the receiving plan would begin on the first day of the employee's tax year for which he or she made designated Roth contributions to the transferring or receiving plan, whichever is earlier.

The proposed regulations would take a different approach for a rollover from a Roth 401(k) to a Roth IRA. A similar five-year rule applies to Roth IRA distributions, but the period begins with the first tax year for which the individual makes a contribution to any Roth IRA. However, rather than give individuals credit for the time since they first made contributions to the Roth 401(k), the proposed regulations would provide that this time does not count in applying the five-year rule to the Roth IRA. Of course, if the individual had established and started contributing to the Roth IRA at least five years before the rollover, the five-year rule would be satisfied for all assets in the account, including those attributable to the rollover.

For rollovers...