Clear hurdles for Roth 401(k) rollovers

Roth nest eggThe latest “newfangled” retirement plan being pushed by the IRS is the Roth 401(k) plan. Typically, a company will add the Roth feature to an existing traditional 401(k) plan.

Alert: The IRS has issued new guidance on in-plan Roth 401(k) rollovers. (Notice 2013-74) It is intended to encourage more 401(k) plan participants to make the move in the wake of the American Taxpayer Relief Act of 2012 (ATRA).

A designated Roth 401(k) provides the same lure of tax-free payouts as a Roth IRA, but at a current tax cost.

Here’s the whole story: As with a Roth IRA, qualified distributions from a designated Roth 401(k) account in existence at least five years are 100% federal-income-tax-free. Qualified distributions include those made after age 59½, due to death or disability or to pay first-time home buyer expenses (up to a lifetime limit of $10,000). Conversely, regular 401(k) distributions are taxed at ordinary income rates, which can be as high as 39.6%. But contributions to a Roth 401(k) are made on an after-tax basis as opposed to a pre-tax basis for a regular 401(k) account.

Under ATRA, an employee participating in a 401(k) can elect to have the plan transfer any amount to a designated Roth account. Thus, you can effectively roll over funds within the 401(k) plan into the designated Roth account without paying the 10% tax penalty that usually applies to pre-age 59½ distributions, although the transfer is subject to regular income tax.

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Highlights of new notice  

The IRS explained that the following may be rolled over to a designated Roth account in the same plan: elective deferrals in 401(k) and 403(b) plans; matching contributions and nonelective contributions, including qualified matching contributions and qualified nonelective contributions; and annual deferrals made to governmental 457 plans.

If an amount is rolled over to a designated Roth account, the amount rolled over and applicable earnings remain subject to the distribution restrictions applicable to the amount before the in-plan Roth rollover. No tax withholding applies because the amount is not distributable (other than for purposes of making an in-plan Roth rollover).

Plans may limit the type of contributions eligible for an in-plan Roth rollover and the frequency of such rollovers. A plan with an ongoing qualified Roth contribution plan would not violate the tax law if it discontinued in-plan Roth rollovers. However, an amendment to eliminate in-plan Roth rollovers is subject to rules on whether the timing of a plan amendment discriminates in favor of highly compensated employees.

In addition, if an in-plan Roth rollover is the first contribution made to an employee’s designated Roth account, the required five-year period of participation for a qualified distribution begins on the first day of the first tax year in which the employee makes the in-plan Roth rollover.

Usually, a plan amendment must be adopted by the last day of the first plan year in which the amendment is effective. However, to accommodate changes for the 2013 plan year, the IRS is extending the deadline to Dec. 31, 2014.

Online resource: Access the entire Notice.