IRS Releases Guidance On Contributing Unused PTO Time To 401(k) Plans, Rollovers From Roth 401(k) Plans, And RMD Distributions

(Published October 26, 2009)

 

The IRS has released a blizzard of rulings that encourage employees to contribute more into their 401(k) accounts.  Included in this paper blitz are two rulings that allow employees to contribute unused annual time off into their plans, one ruling that allows automatic contributions to increase as employees' salaries increase, a notice regarding distributions from Roth 401(k) plans, and model plan amendments and notices. 

 

Contributing Time Off

The IRS has clarified that employees may contribute, or have contributed on their behalf, unused annual paid time off (PTO) or PTO they have accrued at termination, into their 401(k) accounts.  However, the overall limitation on employees' contributions, otherwise called the section 415 limitation, continues to apply.

 

PTO contributions are non-elective contributions if the PTO plan doesn't allow employees to carry unused PTO into the next year, and the 401(k) plan requires that the PTO be contributed into the plan.  Snag: The value of the PTO that must be distributed to employees because the section 415 limit is exceeded is included in their gross income in the year received, and is subject to the 10% tax on early withdrawals, unless employees are 59½ years old or they terminate after reaching the age of 55.

 

PTO contributions are elective contributions (i.e., pre-tax contributions) if the PTO plan allows employees to carry some PTO into the next year, and to contribute some or all of the remainder into the 401(k) plan.  Similarly, terminating employees may elect to contribute some of their PTO into the plan.  Same snag: The value of PTO that must be distributed to employees because the section 415 limit is exceeded is included in their gross income in the year received.  New twist: The value of PTO paid to employees who don't contribute all of their PTO into the 401(k) plan, and that isn't carried over into the next year, is subject to payroll taxes.

 

Auto-Enrollment Plans

Employers may amend their 401(k) plans to include qualified automatic contribution arrangements (QACAs) or eligible automatic contribution arrangements (EACAs).  These 401(k) plans require employees to opt out to receive their full salaries.  QACAs and EACAs share many characteristics, but EACAs may allow employees who opt out to receive distributions of their automatic contributions.

 

The IRS says that for QACAs and EACAs, automatic contributions may increase in the second and subsequent plan years based on increases in employees' salaries.  The IRS has also clarified that increases in default contributions into QACAs or EACAs may be made on dates other than the first day of the plan year (e.g., employees' anniversary dates or another designated date).

 

The IRS has also released sample plan amendments for QACAs and EACAs. 

 

Rollovers From Roth 401(k) Plans 

The income that accumulates in after-tax Roth IRAs generally isn't taxed.  Roth 401(k)s, which also require after-tax contributions, have the same tax advantages upon distribution.  However, for years beginning before 2010, restrictions apply to Roth IRAs, so departing employees who want to directly roll their pre-tax, traditional 401(k) assets into Roth IRAs can't do so if their modified adjusted gross income exceeds $100,000, or they're married but file separate returns.  These restrictions disappear completely and forever beginning in 2010.

 

Regardless of the income and filing restrictions that apply to Roth IRAs, these four rules apply when employees who hold 401(k) assets, including Roth 401(k) assets, terminate employment.

• Employees who don't directly roll over their 401(k) assets into another qualified plan or an IRA are subject to a 20% withholding tax.
  
  

• Roth 401(k) assets may only be rolled over into Roth IRAs.
  
  

• Employees may convert non-Roth IRAs into Roth IRAs, but the amount converted is included in their income and is taxable.
  
  

• Direct rollovers from traditional 401(k) plans into Roth IRAs aren't subject to the 20% withholding tax or the 10% tax on early withdrawals, even though the rollover amounts, less any after-tax contributions, are includable in employees' gross income and are taxable.

While Roth IRAs/401(k)s will become better deals once the income and filing restrictions expire, some important constraints remain.  For example, taxpayers must hold their Roth accounts for at least five years before distributions achieve tax-free status.  This holding period could be problematic for employees who terminate before the five years lapse.  The IRS has clarified that the holding period and other limitations don't apply to rollovers from Roth 401(k)s into Roth IRAs.  In addition, for rollovers from Roth 401(k)s into Roth IRAs before December 31, 2009, no income or filing limits apply, even though the limits apply to Roth IRAs, the IRS said. 

 

Employee Notices 

Employees who terminate employment must receive a notice regarding their distribution options.  To make it easy, the IRS has created a model notice plans may use.  The last version of this model notice was issued in 2002.  The IRS has now updated this model notice.  Also included is a new notice related to rollovers of Roth 401(k) assets. 

 

Required Minimum Distributions 

For 2009, retirees aren't required to take required minimum distributions (RMDs) from their retirement plans or IRAs.  Guidance from the IRS gives plan participants who have already received their RMDs for 2009 until the later of November 30, 2009, or 60 days after the date they received their RMDs, to roll over their RMDs into IRAs or another employer's plan.

 

The IRS has also provided plan sponsors with two sample plan amendments that they may adopt or use to amend their plans to either stop or continue 2009 RMDs.  Both plan amendments provide that plan participants or beneficiaries can choose to receive their 2009 RMDs, or not.  Also, both amendments allow employers to offer direct rollover options of certain 2009 RMDs.  Sponsors have until the last day of the first plan year beginning after January 1, 2011, to adopt the appropriate amendment.  Caution: Sponsors may need to tailor the sample amendments to their plan's particular terms and administrative procedures.