IRS Provides Guidance on In-Plan Roth Conversions
June 13, 2014
Harter Secrest & Emery LLP
Sponsors of 401(k), 403(b) and governmental 457(b) plans can allow their participants to convert pre-tax and traditional after-tax accounts into funds able to qualify for favorable Roth tax treatment. The IRS has issued guidance on how plans can take advantage of this design option.
Roth elective deferrals have been available to 401(k) and 403(b) participants under the Internal Revenue Code since 2006 and are now available to governmental 457(b) participants. Generally, Roth contributions are made on an after-tax basis, rather than on a pre-tax basis like traditional 401(k) and 403(b) contributions. Participants pay current federal income taxes on their Roth contributions, and are then able to withdraw all Roth amounts (both contributions and any associated earnings) on a tax-free basis so long as certain distribution requirements are satised. Generally, tax-free distribution requires that (1) at least ve taxable years have elapsed since the rst year a Roth contribution is made and (2) distributions be made after the participant attains age 59 ½, becomes disabled or dies. Participants who do not meet these requirements are taxed on investment earnings, but not on withdrawn contributions.
Prior to 2010, participants could only convert a pre-tax account to a Roth account “outside” of the plan – i.e., the participant was required to receive a distribution from the plan and then roll it over to a Roth IRA. The Small Business Jobs Act of 2010 (the “SBJA”) included a new “in-plan” Roth conversion option that allowed plan sponsors to amend plans that allowed Roth contributions to permit participants to convert pre-tax or traditional after-tax amounts into Roth amounts in the same plan. Later in 2010, the IRS issued a Notice clarifying the mechanics of such conversions and providing other related guidance. The in-plan Roth conversions created by the SBJA were restricted to amounts that were currently distributable under the plan and qualied as “eligible rollover distributions” under the Internal Revenue Code. Due to federal restrictions on in-service withdrawals, this meant that for non-Roth elective deferrals and certain types of company contributions (most notably safe harbor contributions), in-plan Roth conversions generally were only available to participants who were age 59½ or older or upon termination of employment.
The American Taxpayer Relief Act of 2012 removed this limitation (effective for in-plan Roth conversions made after December 31, 2012), and plans that provide for Roth contributions are now permitted to allow employees to convert “not otherwise distributable” amounts in addition to the previously eligible amounts. This change raised a number of recordkeeping and other concerns, which the IRS addressed in Notice 2013-74.
The new guidance provides timeframes during which plan sponsors may adopt amendments related to in-plan Roth conversion features, and claries several issues which plan sponsors should be aware of when implementing or administering such conversions. In general, the new guidance enhances, but does not change or supersede, prior guidance regarding Roth conversions.
Which assets are eligible for rollover?
All vested amounts (including both contributions and earnings) in a 401(k), 403(b) or governmental 457(b) plan that permits Roth contributions are now eligible for in-plan Roth conversions, regardless of whether the participant has experienced a distributable event, including:
Elective deferrals in a 401(k) or 403(b) plan;
Employer matching and non-elective contributions; and
Annual deferrals made to a governmental 457(b) plan.
However, it is important to bear in mind that only vested amounts may be converted. Also, only a participant, a surviving spouse beneciary, or a spousal alternate payee under a QDRO can do an in-plan Roth conversion, with most employers restricting conversions to participants only.
Can the plan sponsor impose any restrictions on in-plan Roth conversions?
Plan sponsors can limit both the types of contributions eligible for in-plan Roth conversion and the frequency of such conversions. For example, a plan sponsor could permit in-plan Roth conversions only for pre-tax 401(k) deferrals or only for amounts that are otherwise distributable. Similarly, a plan sponsor could limit in-plan Roth conversions to only once per participant each year. However, such restrictions are subject to the nondiscrimination requirements that are generally applicable to plan benets, rights and features.
Can the plan sponsor discontinue an in-plan Roth conversion feature?
A plan sponsor can amend an eligible plan to discontinue an in-plan Roth conversion feature without violating the Internal Revenue Code’s prohibition on eliminating protected benets (so long as the timing of the amendment, or series of amendments, does not have the effect of discriminating signicantly in favor of highly compensated employees or former highly compensated employees).
Guidance on the administration of in-plan Roth conversions
Distribution restrictions: Any plan distribution restrictions that apply to a non-Roth amount that is not otherwise distributable before it is converted under an in-plan Roth conversion continue to apply to the converted amount. Thus, for example, converted pre-tax deferrals are not eligible for in-service distribution prior to age 59 ½ except to the extent the participant qualies for a hardship distribution.
Distribution rights protected: Any distribution right that a participant had prior to an in-plan Roth conversion continues to apply to the converted amount. For example, if a plan allows in-service withdrawals of after-tax contributions, after-tax contributions converted to Roth money must continue to be distributable at any time.
$5,000 cash-out limit: Any converted amount continues to be taken into account for purposes of determining whether a participant’s account balance exceeds the $5,000 mandatory cash-out limit.
Spousal consent: Since an in-plan Roth conversion is not treated as a distribution, it does not require spousal consent (although spousal consent will be required for distributions postconversion to the extent it would have been necessary pre-conversion).
Plan loans: A plan loan transferred to a participant’s Roth account in an in-plan Roth conversion without changes to the payment schedule is not treated as a new loan.
Withholding on rollovers: No withholding is required on amounts converted under an in-plan Roth conversion option. In addition, no voluntary withholding is permitted on an in-plan Roth conversion if the amount is not otherwise eligible for distribution, since money cannot leave the plan.
Since those amounts will be taxable to the participant in the year of conversion, it is important for participants to understand that they may need to increase their withholding rates or make estimated tax payments to cover their income tax liability resulting from the conversion.
Special Tax Notice: Plan sponsors need to give a Section 402(f) notice (or “Special Tax Notice”) regarding the tax consequences of rollover distributions when a participant elects an in-plan Roth conversion of an otherwise distributable amount. No Special Tax Notice is required for an in-plan conversion of non-distributable amounts.
Ten percent tax on early distributions: The 10% penalty tax on early distributions (i.e., prior to age 59 ½) does not apply in the case of an in-plan Roth conversion. However, if a participant withdraws any of the amount converted to a Roth amount within five years (measured from the first day of the tax year in which the conversion is made) and the participant has not yet reached age 59 ½ and does not meet another exception to the 10% early distribution tax at the time of such later distribution, and does not roll over the withdrawal to another designated Roth account or IRA, the distribution will be subject to the 10% tax to the extent that tax would have applied in the year of conversion.
Five-year holding period: If an in-plan Roth conversion is a participant’s first Roth contribution, the five-year period of participation required for tax-free Roth treatment begins on the first day of the taxable year in which the in-plan Roth conversion is made.
Treatment of excess amounts: Any amount rolled over into a Roth account that is later determined to exceed legal limits on plan contributions (such as an excess deferral contribution) must be distributed from the Roth account.
Other considerations: For plans with employer securities, an in-plan Roth conversion is treated as a distribution for purposes of determining eligibility for the special tax rules on net unrealized appreciation. In addition, an in-plan Roth conversion must be counted for purposes of determining a plan’s top-heavy status.
Deadline for plan amendments
The deadline for adopting plan amendments providing for in-plan Roth varies by plan type:
For most plans: Plan sponsors have until the later of the last day of the plan year in which the amendment is effective or December 31, 2014.
For safe harbor 401(k) plans: Although most mid-year amendments to safe harbor 401(k) plans are restricted, the IRS included a one-time exception to permit plan sponsors to add in-plan Roth conversions mid-year, so long as the amendment is executed by December 31, 2014. Thereafter, the amendment will need to be adopted in advance of a plan year in order to be effective for the year.
For 403(b) plans: Plan sponsors that have adopted timely written plan documents have until the later of the last day of the plan year in which the amendment is effective or the end of the remedial amendment period for 403(b) plans (once it has been announced by the IRS). The IRS did not address safe harbor 403(b) rules.
These deadlines also apply to the adoption of amendments permitting Roth deferrals and rollovers into designated Roth accounts.
Next steps for 401(k), 403(b) and governmental 457(b) plan sponsors
Determine whether your workforce would benefit from an in-plan Roth conversion feature (and from Roth deferrals, if your plan does not currently provide for them).
If you decide that this is a plan feature that you would like to offer to participants, you will need to:
- Contact your recordkeeper or third-party administrator to confirm it is willing to implement and administer the feature, and to identify any restrictions it imposes on conversion features.
- Amend your plan within the applicable timeframe. If your plan does not allow Roth contributions, you will need to add this feature.
- Ensure that your payroll staff understands the associated withholding rules.