Roth 401(k) contributions are taking off, especially since the Pension Protection Act of 2006 made the accounts permanent. But once your clients have invested in Roth 401(k)s, how do they get the money out or roll it into Roth IRAs? When will distributions be qualified and tax-free? The IRS answered these questions in the final Roth 401(k) and 403(b) distribution regulations, effective April 30, 2007. These regulations generally apply to tax years beginning Jan. 1, 2007. For simplicity, we will only cover Roth 401(k)s, but all the information that follows also applies to Roth 403(b)s. If you want to help your clients be in the best position to take advantage of these new regulations, make sure they open a Roth IRA sooner rather than later.

Contribution Rules

The Roth 401(k), first available in 2006, is governed by the same rules as other 401(k) plans. An employer does not have to offer a Roth option to its employees. There are no income limits for the employee making Roth 401(k) contributions, although some highly compensated employees may not be able to contribute the full amount, just as they cannot contribute the full amount to the 401(k).

The contribution limits are the same as the elective contribution limits for the employer plan. And, just as the contribution limits for a traditional IRA and a Roth IRA are combined so that you cannot contribute more than $4,000 to all IRAs if you are under age 50, the Roth 401(k) and 401(k) limits are combined. For 2007, the maximum contribution amount is $15,500 plus a $5,000 catch-up for employees age 50 or older.

A qualified distribution is not subject to taxes or penalties. The distribution is qualified if the Roth 401(k) is held for more than five years and any of the following applies: The employee is over age 59½; the employee has died; or the employee is disabled. A qualified distribution consists entirely of basis. When these funds are transferred to another employer's Roth 401(k) or to an individual Roth IRA, they go into the new account as basis and are available for distribution income tax-free.

For example, assume it was possible for Rachel, now age 62, to establish a Roth 401(k) with her current employer ten years ago. Any distribution Rachel takes from her Roth 401(k) plan will not be subject to income tax since the plan was established more than five years ago and Rachel is over the age of 59½.

A distribution that isn't qualified is subject to the pro-rata rule; it is not subject to the ordering rules used in a distribution from a Roth IRA. The nontaxable amount of the distribution is generally determined by dividing the employee's deferrals (basis) by the balance in the Roth 401(k) and multiplying the amount distributed by the result.

Roth employer accounts can be rolled to individual Roth IRAs, but the reverse is not true. Employee contributions to the Roth 401(k) are after-tax and are governed by the rules that apply to after-tax contributions in an employer plan. Roth 401(k) funds can be rolled to another employer's Roth plan only if the receiving plan allows it. The amount that can be rolled depends on whether the transfer was done as a direct rollover (a trustee-to-trustee transfer) or a 60-day rollover. With a direct rollover, the entire plan balance can go to an employer Roth plan or to an individual Roth IRA. With a 60-day rollover, only taxable amounts can be rolled over to another Roth employer plan, or the entire plan balance can go to an individual Roth IRA.

In a partial 60-day rollover of a nonqualified distribution to a Roth IRA, the amount rolled into the Roth IRA comes first from taxable amounts distributed from the Roth 401(k). This means that the employee is rolling the taxable earnings portion into the Roth IRA first, and the balance of the distribution comes from the tax-free part.

Roth 401(k)s have their own five-year holding rules. Unlike Roth IRAs, where there is only one five-year period that starts with the establishment of the owner's first Roth IRA, Roth 401(k)s have separate five-year holding periods for each employer's account. If a client works for two different companies and participates in the Roth 401(k) plan at each company, the client will have a separate five-year period for each plan.

The IRS final regulations spell out how the five-year holding period will be determined in each rollover situation, depending on how the funds were transferred (direct or 60-day rollovers) and where the funds are transferred to (a Roth 401(k) or Roth IRA).

Rollover: 401(k) to 401(k)

The rules are different for 60-day rollovers and for direct rollovers, and are more favorable for the latter.

Direct rollover (trustee-to-trustee transfer) to a new Roth 401(k). Edna started contributing to her Roth 401(k) in 2006. In 2009, she starts a new job and does a direct rollover of her entire Roth 401(k) to the new employer's plan. The beginning date of Edna's holding period in the old plan was Jan. 1, 2006, and in the new plan is Jan. 1, 2009. Because Edna did a direct rollover, she gets to use the earlier of the two dates, Jan. 1, 2006, as the beginning date of her holding period for the new plan. When those same funds are transferred as a 60-day rollover, the employee must use the holding period of the receiving plan.

Sixty-day rollover to a Roth 401(k). Assume Edna did a 60-day rollover of the taxable amount only into the new employer's Roth 401(k) plan. She cannot carry over the beginning date of the holding period from her old plan, so the new beginning date is Jan. 1, 2009, the date applicable in the receiving plan.

Rollover: 401(k) to IRA

The five-year holding period is never carried over to an individual Roth IRA. If the Roth IRA has already satisfied the five-year period, then the employer funds are deemed to have also met the holding period, even if they were only in the Roth 401(k) for a year. This is another reason for qualifying individuals to establish a Roth IRA. If they don't qualify this year, they'll qualify in 2010 when all restrictions on converting to a Roth IRA are lifted and they can establish a Roth IRA by doing a conversion.

Rollover to an existing Roth IRA. In 2009, assume Edna rolled her entire Roth 401(k) into the Roth IRA she established in 2004. Since Edna cannot carry over the beginning date of the holding period in the Roth 401(k) plan, she must use the beginning date in the Roth IRA. Since the Roth has been open for more than five years, the Roth 401(k) funds she rolled in satisfy the five-year holding period even though they were only in the Roth 401(k) for three years.

Rollover to a new Roth IRA. Assume Edna did a 60-day rollover of the entire Roth 401(k) to the Roth IRA that she established in 2009. She cannot carry over the beginning date of the holding period, so she uses the beginning date in the Roth IRA. Since the Roth IRA was just established, the five-year holding period for the Roth 401(k) funds starts over as of 2009.

Rollover of qualified distribution to a new Roth IRA. Let's use our Rachel example again. Rachel established a Roth 401(k) with her current employer 10 years ago and is taking early retirement at age 62. Rachel never had a Roth IRA, so she does a direct rollover of her entire Roth 401(k) balance to a new Roth IRA. Her Roth IRA will have to satisfy a five-year holding period before she can take a qualified distribution, even though the rolover funds have been in the Roth 401(k) for 10 years and she is over age 59½. But the rollover funds from her Roth 401(k) are considered basis in the Roth IRA since they were a qualified distribution from the plan. Under the Roth IRA ordering rules, any distribution Rachel takes is considered to come first from her basis, and distributions of basis will be income tax-free.

If your clients have one or more Roth 401(k) plans, now is the time to study the new regulations. When it comes time for clients to take distributions, you'll be in a better position to help them make the right decisions.

Ed Slott, CPA, is a nationally recognized IRA distribution expert, professional speaker and author of several IRA books, including Your Complete Retirement Planning Road Map. He's the publisher of Ed Slott's IRA Advisor, a monthly IRA newsletter. For more, visit www.irahelp.com.