ERISA-Extra Summer 2017

Are designated Roth accounts right for you?

Designated Roth accounts—which allow plan participants to make after-tax contributions but to take qualified distributions free of federal income tax—are increasing in popularity. In 2017, approximately 55% of U.S. employers surveyed by the Society for Human Resource Management offered a Roth 401(k) or similar defined-contribution retirement savings plan—as compared to 38% in 2013.1

Reasons for this growth include the increased tax diversity that Roth accounts can afford; retirees have greater flexibility to draw from nontaxable income to minimize their tax exposure from year to year. Another reason—attractive to participants with higher incomes and other assets—is the flexibility to roll funds in the designated Roth account to a Roth individual retirement account (IRA), which would allow the account owner to avoid lifetime required minimum distributions and leave the assets intact for heirs.2

However, a designated Roth contribution option does entail some additional obligations for the plan administrator. Below is an overview of the general rules and requirements that apply.

Establishing the Roth option

To set up a qualified Roth contribution program, plan sponsors must adopt an appropriate plan amendment. The deadline is the end of the plan year for which the amendment is effective.3 Plans may not limit contribution options to only Roth contributions; instead, they must offer Roth contributions only in conjunction with the option for traditional, pretax contributions.4

The plan must establish a separate “designated Roth account” for the designated Roth contributions of each employee (as well as for any earnings allocable to those contributions) and maintain separate recordkeeping for each such account.5 To meet the separate accounting requirement, the plan must:

  • Credit contributions to, and debit withdrawals from, a designated Roth account maintained for the employee who made the designation
  • For the employee’s designated Roth account, maintain a record of the employee’s investment in the contract (i.e., designated Roth contributions that have not been distributed)
  • Separately allocate gains, losses, and other credits or charges to the designated Roth account and other accounts under the plan on a reasonable and consistent basis6

Qualified distributions

The requirements for “qualified distributions” from designated Roth accounts are similar but not identical to those for Roth IRAs. Generally, qualified distributions may be made (1) after the five-tax-year period beginning with the first tax year for which the taxpayer made a designated Roth contribution to any designated
Roth account established for the taxpayer under the same plan, and (2) on or after attaining age 59½, at or after death, or on account of a disability.7 In contrast to the rule governing qualified distributions from Roth IRAs, qualified distributions for a first-time home purchase are not allowed from designated Roth accounts.

If a distribution is not a qualified distribution, it is generally included in gross income only to the extent that the distribution is a pro rata return of income on the contract.8 The plan sponsor must maintain a record of the participant’s five-tax-year holding period.9


Plans may not allocate to the designated Roth account any forfeitures or any contributions other than designated Roth contributions and qualified rollover contributions.10 For example, any matching contributions must be added
to the pretax account.11

Plans may allow eligible participants to make designated Roth contributions up to the limits set for traditional pretax contributions.12 For 2017, that limit is $18,000 (plus $6,000 in catch-up contributions for those 50 and older).13 The limits apply to the sum of a participant’s designated Roth contributions and pretax elective deferrals. Note that the elective deferral and catch-up limits are much higher than the contribution limits that apply to Roth IRAs ($5,500 and $6,500, respectively, in 2017).14 And in contrast to the rules governing Roth IRAs, no income level phase-outs apply to designated Roth account contributions.

Employees may choose to either wholly or partially designate their deferrals as Roth contributions.15 However, once made, the designation is irrevocable with respect to those contributions.16 Participants must be allowed to change their contributions for future contributions at least once per year.17

Generally, a designated Roth contribution must satisfy the requirements that apply to elective contributions made under the 401(k) plan, such as the nonforfeitability and distribution restrictions for elective contributions, as well as the actual deferral percentage (ADP) test.18


As part of a designated Roth arrangement, the sponsor may further amend the plan to allow employees to make “in-plan rollovers” of amounts from their traditional 401(k) accounts to their designated Roth accounts.19 Participants who choose to make in-plan Roth rollovers will be taxed on the rollover of any amounts previously untaxed.20

Plans may allow such in-plan Roth rollovers even where the amounts are not otherwise distributable under the plan terms.21 Once the rollover is completed, however, any distribution restrictions that applied before the rollover will again apply to both the rolled-over amount and any earnings thereon.22 

In-plan Roth rollovers are generally not subject to the 10% additional tax on early distributions.23 However, they are subject to a special recapture rule when a plan distributes any part of an in-plan Roth rollover within the five-tax-year holding period beginning with the first day of the participant’s tax year in which the rollover was made. Under this rule, the distribution would be subject to the 10% additional tax unless an exception applies.24 However, the recapture rule does not apply to a distribution rolled over into another designated Roth
account or a Roth IRA owned by the participant.

Plans may also accept direct rollovers from designated Roth accounts in other plans and rely on reasonable representations made by the plan administrator for
the transferor plan.25 Information that must be provided to the recipient plan includes the first year of the five-taxable-year period of participation and the portion of the distribution that is attributable to investment in the contract, or a statement that the distribution is a qualified distribution.26

The foregoing is a broad overview of the relevant rules, and many additional rules may apply. If you are considering adding a designated Roth contribution option to your plan, please talk with your UBS Financial Advisor.

Recent development: IRS interpretation of loan limits

The IRS recently issued a memorandum to its plan examiners to clarify that it would accept two alternative interpretations of the tax law’s plan loan limit that is
applicable when a participant seeks to take more than two loans during a one-year period. This interpretation gives additional flexibility to plan sponsors.

To avoid treatment of a loan as a taxable distribution, tax rules require that the loan, when added to the outstanding balance of all loans, does not exceed the lesser of

  • $50,000, reduced by the excess (if any) of
    • The highest outstanding balance of loans during the one-year period ending on the day before the date on which such loan was made, and
    • The outstanding balance of loans on the date on which such loan was made
  • The greater of
    • half the present value of the vested accrued benefit
    • $10,00027

The $50,000 limit under Subsection (i) can be confusing because two amounts must be calculated when a participant has previous loans: the participant’s outstanding loan balance on the date of the new loan and the “highest outstanding balance” of loans during the one-year period. For example, if a participant had a loan balance of $35,000 at any time during the one-year period prior to the new loan, then the most that could be borrowed would be $15,000, even if that $35,000 loan had been completely paid off at the time of the second loan.

In the recent memorandum, the IRS addressed the question of what is the “highest outstanding balance” when there were two (or more) prior loans during the oneyear period. The IRS stated that the plan may choose to subtract from the $50,000 figure either (1) the highest single balance during the one-year period or (2) the highest balance of all prior loans taken during the one-year period.

Example: Bob borrows $30,000 in February and fully repays it in April. Bob takes out another $20,000 in May and fully repays it in July. Bob applies for a third loan in December. Over the one-year prior to the date of the third loan the “highest outstanding balance” would appear to be $30,000. However, because “highest outstanding balance” is ambiguous when two prior loans are involved, the IRS would allow a plan to add the two loan balances together ($30,000 + $20,000 = $50,000) to determine that no third loan is available.

In the example, the second interpretation generally reduces the ability of participants to take a third loan in a one-year period. Plans seeking to curb multiple plan loan borrowings may therefore want to consider using the second alternative.

Your UBS Financial Advisor can help you review your plan loan program, but to the extent an amendment may be necessary to clarify your intent, you will need to consult with your legal or other advisor.

The importance of internal controls

Having strong internal controls—business policies and procedures designed to detect and prevent errors—is essential for the proper administration of a qualified
retirement plan. According to the IRS, plan audits and voluntary correction submissions reveal that plans often lack adequate internal controls.28

Performing a self-audit

Your plan’s internal controls should include procedures for regularly reviewing your plan operations and updating your plan document. A self-audit of your plan may uncover weaknesses in your internal controls.

Generally, the key inquiries when conducting a self-audit are the following: (1) Who is responsible for a specific plan administration task? (2) Is it being completed correctly? and (3) Once identified, is a correction process being followed? Below are some more specific issues that a self-audit should cover.


  • Eligibility. Verify that years of service were correctly calculated for purposes of eligibility. Confirm that the list of eligible employees is complete—e.g., it should include terminated employees who may have been eligible to contribute for part of the year, as well as any employees at a related company with common ownership who may be eligible for participation.
  • Contributions. Are deposits being made according to strict DOL timing guidelines? Verify that the definitions of “compensation” used for allocations, deferrals and testing are consistent with what is provided in the plan document. Verify the correct amount of matching and nonelective contributions. Check that plan service providers received accurate compensation and ownership records. Check to make sure that annual contribution and compensation limits were observed. Compare salary deferral election forms with the amounts deducted from employees’ wages.
  • Loans and distributions. If plan loans or hardship distributions are allowed, are such distributions made and approved in accordance with DOL and IRS requirements? Review in-service, termination and loan distribution forms to make sure they conform to your plan document. (Vendors will sometimes use the same form for different sponsors.) Verify marital status and spousal consent for plan distributions. Ensure participants and beneficiaries timely received their required minimum distributions (RMDs).
  • Testing and administration. Has all annual testing been completed? Have highly compensated employees and key employees been properly identified? Are all applicable notices being distributed to participants? Have you properly verified the validity of rollover contributions? Verify that years of service were accurately determined for vesting.

Plan document

The IRS identifies the failure to timely amend the plan as a common plan error.29 Frequently during plan audits, the employer is unable to locate the necessary documentation to prove that the plan was timely amended to conform to current law. If so, the employer will need to enter into an audit closing agreement under Audit CAP.

A few months before your plan year ends, ask your legal or other advisor if there are any legal or operational changes that will need to be in place for the coming year. If you change your plan document, make the corresponding change to the summary plan description and communicate the changes to plan participants.

Please contact your UBS Financial Advisor if you would like to discuss the effectiveness of your plan’s internal controls.

Understanding the EPCRS

The IRS allows plans to use the Employee Plans Compliance Resolution Systems (EPCRS) to remedy mistakes and avoid the consequences of plan disqualification. There are three methods of correction:

Self-Correction Program (SCP)—permits a plan sponsor to correct certain insignificant “operational” failures without contacting the IRS or paying a fee. The SCP is not available for problems with the plan documents (e.g., not updating it for changes in the law). The plan sponsor must be able to demonstrate that effective practices and procedures are in place to promote overall compliance with the law and to prevent the recurrence of the mistakes.30

Voluntary Correction Program (VCP)—permits a plan sponsor—at any time before audit—to pay a fee and receive IRS approval for correction of plan failures. The plan sponsor must propose changes to the plan’s administrative procedures to ensure that the mistakes do not recur.

Audit Closing Agreement Program (Audit CAP)—permits a plan sponsor to correct a plan failure while the plan is under audit and pay a negotiated sanction.31

If an audit is ultimately undertaken, the revenue agent begins by evaluating the plan’s internal controls to determine whether to conduct a focused or expanded
audit. The strength of the plan’s internal controls will help determine the amount of any sanction assessed under Audit CAP.32