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IRS Finalizes Guidance on Roth 401(k) Distributions

When the Economic Growth and Tax Relief Reconciliation Act of 2001 (“EGTRRA”)created the concept of a “Roth 401(k) contribution,” things got off to a slow start. For one thing, it was not at all clear how the Roth IRA concept, which has been around for some time, would be transplanted to an employer-sponsored plan.

Moreover, the Roth 401(k) concept was slated to sunset in 2010 – along with the rest of EGTRRA’s provisions. Many employers and their employees (not to mention 401(k) record keepers) wanted nothing to do with such a short-term phenomenon. The Pension Protection Act of 2006 solved this latter problem, by making the Roth 401(k) a permanent part of the Tax Code (at least, to the extent that any part of that Code can be considered “permanent”).

Over the years, the IRS has been working to solve the former problem. In early 2006, the IRS finalized regulations concerning Roth 401(k) contributions. It also proposed regulations on Roth 401(k) distributions. In April of 2007, the IRS finalized those regulations – thereby answering many of the questions that had discouraged 401(k) plan sponsors from adopting a Roth contribution feature.

For those who are not familiar with the Roth concept, its real magic lies in its ability to allow an employee to entirely avoid taxation on the earnings that accumulate within a designated Roth account. To gain this tax-free treatment, however, the employee must give up the tax exclusion that would otherwise apply to a regular 401(k) contribution. He or she must also defer any distribution from a plan’s Roth account until at least five years after making the first Roth contribution to the plan and after either attaining age 59½, dying, or becoming disabled.

One point made abundantly clear by these recent regulations is that Roth 401(k) distributions are not subject to the same taxation rules as distributions from Roth IRAs. Although the two retirement vehicles are similar, the IRS pointed to differing statutory provisions in declining to make the two sets of rules identical. Thus, individuals who are familiar with the rules governing Roth IRAs will want to avoid making the assumption that they also know the rules governing Roth 401(k) distributions.

From a practical standpoint, these recent regulations – which are generally effective as of January 1, 2007 – should make it easier for employers to adopt a Roth 401(k) feature. Certainly, 401(k) record keepers can no longer contend that the rules governing these accounts are unclear. Depending on the nature of an employer’s work force, this may be the time to consider adopting a Roth 401(k) feature.