Rolling over from a DRAC to a Roth IRA

By Natalie B. Choate, Esq.

This year, for the first time, 401(k) and 403(b) participants have the option of sending their salary deferral contributions to either a “designated Roth account” (DRAC) or to a “regular” 401(k) account, assuming the employer has adopted the necessary plan amendment authorizing this.

(Estate planning reminder: A client may need separate beneficiary designation forms for his regular 401(k) and DRAC accounts. For example, if the regular account is left to charity, that’s not the best beneficiary for the income tax-free DRAC.)

Like Roth IRAs, DRACs require the participant to pay income taxes up front when the money is contributed to the plan, but allow later tax-free “qualified distributions” of all plan accumulations after age 59½, disability or death, once a five-year holding requirement is satisfied. That’s where the similarity ends.

A DRAC is part of a qualified retirement plan and has the pluses and minuses of that status. One minus is that DRACs must pay minimum required distributions (MRDs) starting at age 70½ (or upon later retirement, in the case of non-5 percent owners), unlike Roth IRAs, which have no MRDs until after the participant’s death. So for most DRAC participants, the goal will be to roll over the DRAC to a Roth IRA eventually, to avoid the lifetime MRD requirement. That process is tricky because of how the five-year holding period works according to new proposed IRS regulations.

First of all, there is no possibility of rolling over from a DRAC to a Roth IRA until after termination of employment, because elective deferral contributions cannot be distributed for rollover prior to that time. That’s just a long-standing rule for 401(k)/403(b) plans, and DRACs are subject to it, too, since a DRAC is just another account inside a 401(k)/403(b) plan.

Then, once the employee terminates employment and rolls his DRAC to a Roth IRA, he may “lose” all the years he accumulated in the DRAC. Why? Because the Roth IRA five-year holding period begins the first year the individual has any Roth IRA — and that rule doesn’t change just because the Roth IRA receives a rollover from a DRAC, regardless of how long the money was in the DRAC.

This no-carryover rule is actually favorable to someone who has already had a Roth IRA for five or more years. It means the DRAC rollover money coming into the Roth IRA “instantly” meets the five-year requirement, even if it was held in the DRAC for fewer than five years. The rule is also not too bad for a person who rolls a qualified distribution from a DRAC to a Roth IRA: The qualified distribution comes in as 100 percent after-tax money (which can be withdrawn tax-free from the Roth IRA any time). For this person, the Roth IRA’s five-year holding requirement will matter only with regard to post-rollover earnings on the DRAC rollover amount (as to which the individual will have to satisfy the Roth IRA five-year holding period in order to have a qualified distribution).

Who is hurt by the no-carryover rule? The person who receives a non-qualified distribution from the DRAC (i.e., a distribution before the person had reached age 59½ or been disabled and/or before satisfying the five-year requirement for the DRAC) and who did not have a Roth IRA prior to the rollover. All his years in the DRAC will be lost and he will be starting the five-year holding period all over again. But even for this person, that won’t make much difference if he is younger than 54½, because he has to wait five years anyway before he can have a qualified distribution from the Roth IRA (after age 59½).

So planners will have to be extra careful with rolling out of a DRAC for an individual who is within striking distance of age 59½, has no prior Roth IRA, and has built up some years in the DRAC. Or, we could just wait and see if final regulations change this rule or Congress allows DRACs to expire altogether in 2011, as current law provides.

Natalie B. Choate, Esq., an estate planning lawyer with Bingham McCutchen in Boston, is the author of “Life and Death Planning for Retirement Benefits,” the leading professional book on retirement distribution planning. The newest edition can be purchased through her Web site, www.ataxplan.com. This article was previously published in her newsletter, “Choate’s Notes.”

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