Designated Roth Accounts

The tax code allows several kinds of retirement plans that reduce taxes either now or in the future. The 1st types of retirement plans, such as the traditional IRA, saves taxes when contributions to the retirement accounts are made, thus, motivating people to save for their future. Not only are the contributions tax-deductible, but the money can grow tax-free. However, these accounts are tax-deferred accounts, since the government assesses taxes on both contributions and earnings when the money is withdrawn. Later, the government allowed a new type of account, called a Roth IRA, that required contributions with after-tax dollars, but distributions of both contributions and earnings are tax-free. For many people, especially lower income people who did not benefit significantly from the tax savings of traditional, pretax retirement accounts, especially since the pretax contributions do not save on employment taxes, which is usually a greater burden on lower income people, the Roth IRA was a much better deal. Because of the popularity of the Roth IRA, the government changed some of the traditional types of retirement plans — notably the 401(k), the 403(b), and the 457(b) government retirement plans, including the Solo 401(k) plan for the self-employed with no employees — so that the taxpayers could designate some or all of their contributions to a separate designated account within their retirement plan, called appropriately enough, a designated Roth account. Like contributions to a Roth IRA, contributions to a designated Roth account are made with after-tax dollars, but qualified distributions from designated Roth accounts, consisting of both contributions and earnings, are tax-free. However, only employees can contribute to their designated Roth account — employer contributions are permitted only for the tax-deferred accounts. Note that simplified employee pension plans (SEP), also known as a SEP-IRA, and SIMPLE IRAs do not have designated Roth accounts: all contributions to these plans are pretax.

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Although the tax code allows designated Roth accounts, the retirement plan must also allow it. A designated Roth account is set up for each plan participant who requests it and the account is kept separate from the pretax retirement account, facilitating accurate accounting.

Contributions

The plan participant can decide what proportion of her contribution will go to the pretax retirement account or to the designated Roth account. However, the overall dollar limit that applies to these accounts applies to the total contribution to both pretax and designated Roth accounts. So, for instance, the contribution dollar limit for 2015 is $18,000, and for plan participants who are at least 50 by year-end can make a catch-up contribution of an additional $6000, for a total of $24,000. So if a 50-year-old plan participant chooses to save $11,000 in the pretax account, then any contribution to the designated Roth account in the same tax year is limited to $13,000. Once the contribution is made to a designated Roth account, the participant cannot recharacterize the contribution as a pretax contribution. However, distributions from pretax accounts can be rolled over into the designated Roth account, but the participant must pay taxes on the amount of the rollover for the year that it was made.

If the retirement plan provides, the employer can match contributions to a designated Roth account, but the matching contributions are paid into the pretax account rather than the designated Roth account.

Rollovers

Rollovers to or from designated Roth accounts are restricted. A Roth IRA can only be rolled over into another Roth IRA: it cannot be rolled over into a designated Roth account. A designated Roth account can be rolled over into another designated Roth account, but to be excludable from income, the rollover must be direct, from trustee to trustee. Moreover, unlike a Roth IRA, which can accept rollovers from virtually any type of retirement account, rollovers to designated Roth accounts cannot be recharacterized, so pretax accounts cannot be rolled over to designated Roth accounts. Hence, the only permitted rollovers to a designated Roth account must come either from other designated Roth accounts or from a Roth IRA.

Although the 5-year holding period rule applies to each designated Roth account separately, the age of the rolled over account will be determined by the age of the oldest account. So if a designated Roth account that has been held for 5 years is rolled over to another account that was just opened, then the 5-year holding period will be satisfied for the new account.

However, the holding period does not transfer to a Roth IRA. Instead, the holding period for the Roth IRA, including rollover amounts from designated Roth accounts, is determined by the tax year for which a Roth IRA was 1st opened. Since contributions to a Roth IRA can be made up to the tax filing deadline, the 5-year period begins on January 1 for the tax year for which contributions were made. Therefore, if you held a Roth IRA for at least 5 years, then the 5-year holding period is satisfied, so any rollovers from a designated Roth account into any Roth IRA will be immediately available without withdrawn earnings being subject to taxes. Note that, unlike designated Roth accounts, the holding period for all Roth IRAs is determined by the date in which the 1st Roth IRA was opened, so if any Roth IRA was held for at least 5 years, than any rollovers from a designated Roth account into any Roth IRA held by the same taxpayer will satisfy the 5 year holding requirement. Like the designated Roth account, the principal of the Roth IRA can always be withdrawn without taxes or penalties, even if the taxpayer is younger than 59½, but an unqualified withdrawal of earnings will incur a 10% penalty on the earnings. Unlike designated Roth accounts, any withdrawals from a Roth IRA are considered 1st from principal, or basis, then from earnings. So a taxpayer can withdraw all contributions to a Roth IRA at any time without penalty. The major advantage of rolling over designated Roth accounts to Roth IRAs is that there is no required minimum distribution (RMD). Even though designated Roth accounts are funded with after-tax dollars, they are still subject to the RMD for the account when the taxpayer reaches 70½.

Pretax contributions from 401(k), 403(b), and 457(b) retirement plans can also be rolled over into a designated Roth account. However, taxes will have to be paid on the rolled over amounts. Amounts held in a traditional IRA, SEP-IRA, or a SIMPLE IRA cannot be directly rolled over into a designated Roth account, but they can be rolled over into 401(k) type plans as a pretax rollover, then rolled over into the designated Roth account. Moreover, a SIMPLE IRA cannot be rolled over into any other type of retirement plan, except another SIMPLE IRA, until the SIMPLE IRA has been opened for at least 2 years.

If a retirement plan allows in-plan Roth rollovers, participants can rollover amounts held in pretax accounts to a designated Roth account within the same plan, including the portion contributed by the employer. Legally, any retirement plan that allows designated Roth accounts can also offer in-plan Roth rollovers. The rollover can be a direct rollover, in which the funds are transferred directly from trustee to trustee or from the pretax account to the designated Roth account administered by the same trustee, or the participant can rollover the amount received in a distribution to a designated Roth account within the same plan within 60 days of receiving the distribution. The employer is legally obligated, however, to withhold 20% of a distribution paid directly to the recipient for potential taxes; direct rollovers are not subject to tax withholding. Beneficiaries and alternate payees may also make in-plan Roth rollovers, but only if the transferor is eligible for the distribution from the source account.

Distributions

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Distributions from designated Roth accounts follow the same rules as distributions from pretax accounts. Unlike Roth IRAs, where withdrawals can be made at any time, withdrawals from designated Roth accounts, like other qualified retirement plans, are allowed only when the retirement plan allows it. The tax treatment of the distribution depends on whether it is qualified or nonqualified.

Qualified distributions from a designated Roth account are tax-free. A qualified distribution is one that is made to a participant who is at least 59½ and at least 5 years have passed since the beginning of the 1st tax year for which contributions to the account were made, or who has become disabled or died.

If the distribution is not qualified, then the part of the nonqualified distribution attributed to earnings is taxable; the part attributable to contributions is tax-free, since the contributions were made with after-tax dollars. This treatment differs from Roth IRAs, where nonqualified distributions are considered from contributions 1st, then from earnings, but any distributions from designated Roth accounts are prorated between nontaxable contributions and taxable earnings. To calculate the taxable portion of a distribution attributable to earnings, use the following procedure:

Calculating the Taxable Portion of Nonqualified Distributions from Designated Roth Accounts
Taxable Portion of Nonqualified Distribution=Distribution ×Total Earnings
Total Account Balance

So if a designated Roth account has a total balance of $5000, of which $1000 is earnings, then a nonqualified distribution of $2000 will have a taxable portion equal to $2000 × 1/5 = $400.

If the retirement plan allows hardship distributions, then a participant can elect to take a distribution because of a financial hardship, but, unless the distribution is also qualified, the earnings portion of the distribution will be includible in the participant's gross income. However, the tax can be avoided, if the distribution is rolled over into a Roth account within 60 days. A rollover to another designated Roth account in another retirement plan can be made, but the transfer must be a direct rollover.

Some retirement plans will also allow loans, where up to 50% of the value of the retirement account, including pretax and after-tax contributions and earnings can be used as collateral for a loan, up to a maximum loan of $50,000.

Unlike a Roth IRA, but like a traditional IRA, the taxpayer must receive required minimum distributions by April 1 of the year after the year in which the taxpayer reaches 70½, unless the taxpayer is still working for the employer and is not a 5% owner of the employer that sponsors the plan.