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Designated Roth Contributions — Dispelling the Confusion

Lynn Knight

Designated Roth Contributions (DRCs) have been a permissible retirement plan feature since 2006; however, there is still confusion in the retirement plan community regarding DRCs. So you think you know all there is to know about DRCs? Let’s test your knowledge.

Did you know that, unlike Roth IRAs, there is no income limit test for a participant to make DRCs to an eligible retirement plan?

It’s a fact. DRCs eliminated the issue of “high paid earners” and their inability to take advantage of tax-free retirement savings through a Roth IRA. Any participant who meets the plan’s eligibility requirements, regardless of income, can make DRCs to an eligible retirement plan, subject to any applicable nondiscrimination testing.

Can a 457(b) plan sponsored by a tax-exempt (non-governmental) organization have a DRC feature?

The answer is “no.” The only types of retirement plans that may permit DRCs are 401(k), 403(b) and governmental 457(b) plans. No other type of retirement plan is allowed to have a DRC feature. Also, a retirement plan that only allows DRCs but not pre-tax deferrals is not permitted.

What about a 401(a) plan? Can 401(a) plans permit DRCs?

Only retirement plans with a deferral feature can have DRCs. Since a 401(a) plan does not have a deferral feature, it cannot permit DRCs.

What would you say to a 403(b) plan participant who inquires if she can make both DRCs and pre-tax deferrals to the plan in the same tax year?

The response would be “yes”; however, the total amount of DRCs and pre-tax deferrals to a 403(b) plan are limited to $18,000 (in 2016 and before any catch-up contributions).

Let’s add another twist — can a participant make DRCs to a 403(b) plan and, if eligible, Roth IRA contributions in the same year?

The answer is “yes,” since DRCs and Roth IRA contributions are not coordinated. However, Roth IRA contributions must be coordinated with any contributions the participant makes to a Traditional IRA in a calendar year.

What if you were asked by a client if DRCs are subject to the lifetime minimum distribution requirements (RMDs)?

The answer is “yes,” since DRCs follow the RMD rules of pre-tax elective deferrals and must begin to be distributed by the later of when the participant reaches age 70½ or severs employment with the plan sponsor. If your client believes RMDs are not required, your client might be thinking of a Roth IRA where the owner is not subject to the lifetime RMD requirements. Note, however, that in the case of death, the RMD requirements apply equally to distributions from DRCs and Roth IRAs made to beneficiaries after the participant’s or owner’s death.

Question — Assuming the five-year holding period is met, can a retirement plan participant receive a distribution of DRCs tax-free for federal income tax purposes in order to buy her first home?

The answer is “no.” Don’t be confused with the requirements for a qualified distribution from a Roth IRA. For tax-free distributions from both a Roth IRA and a DRC account, the amounts must be held for five years and be distributed due to the individual’s:

1. attainment of age 59½;
2. death; or
3. disability.

However, for a Roth IRA, there is an additional “qualifying event,” i.e., the first-time purchase of a home (up to a lifetime limit of $10,000).

A participant in a governmental 457(b) plan wants to convert some of his pre-tax deferrals to DRCs. How would you respond?

The correct response is that if permitted by the plan document, the participant could “rollover” pre-tax amounts in his account, whether or not the amounts are eligible to be distributed, into his DRC account, paying any applicable income taxes.

Last question — can you always assume that if a DRC is distributed tax-free for federal income tax purposes that state taxes will not apply to the distribution?

The answer is “no,” because not all states conform their retirement plan and/or income tax rules to federal law. A retirement plan participant should be aware of their particular state rules for any potential taxation of DRCs even if the distribution is tax-free for federal income tax purposes.

Lynn Knight, CEBS, is a member of Technical Services for Tax-Exempt Markets at Voya Financial. Lynn has worked extensively in the retirement plan field for a broad spectrum of defined contribution plans, including 403(b), 401(k) and 457(b) plans, both at law firms and with retirement service providers. She also is a member of the NTSA Communications Committee.

This material was created to provide accurate information on the subjects covered. It is not intended to provide specific legal, tax or other professional advice. The services of an appropriate professional should be sought regarding your individual situation. These materials are not intended to be used to avoid tax penalties, and were prepared to support the promotion or marketing of the matters addressed in this document. The taxpayer should seek advice from an independent tax advisor.

Opinions expressed are those of the author, and do not necessarily reflect the views of NTSA, or its members.