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October 6, 2010
In-Plan Roth Conversions
By Kevin Haskell
As many of us in the industry had anticipated (and hoped), legislation was recently passed to allow conversions of pre-tax retirement accounts within certain retirement plans (401(k), 403(b) and as of January 1, 2011, governmental 457(b)) to after-tax Roth accounts. On September 27, 2010, the Small Business Jobs Act of 2010 (the "Act") was signed into law, allowing those eligible participants in retirement plans to convert all or a portion of their pre-tax accounts to after-tax Roth accounts. Seems pretty straightforward, but unfortunately with most new regulations, there are numerous caveats and hurdles that will need to be addressed with future IRS guidance.
Before the Act was passed, retirement plan participants who desired to take advantage of the Roth conversion feature were only able to do so if they converted their pre-tax retirement accounts outside of the Plan to a Roth individual retirement account (IRA). Not only would these employees lose the protection that ERISA provided to their retirement assets (ERISA protection does not apply to IRAs) but many plan participants who desired to make the conversion were restricted from doing so. Only participants who were otherwise able to receive an eligible rollover distribution from the Plan could convert.
Unfortunately, these restrictions remain in place for in-plan conversions. Under current law, distribution restrictions are placed on employee elective deferrals so that an employee can only elect to receive a distribution if they:
• Are age 59 ½
• Have a severance of employment
• Die (whereas only a spouse beneficiary is eligible to convert)
• Become disabled
• Incur a hardship
In addition, even if you meet one or more of these requirements, if your distribution is not eligible to be rolled over (i.e. a hardship distribution, non-spouse beneficiary distribution), converting is also not permitted.
For all other contributions (profit sharing, match, voluntary after-tax, rollovers), a more liberal set of rules apply. The restrictions that are in place for elective deferral contributions do not apply to these contribution types, but the provisions of the Plan prevail. Many retirement plans have their own set of distribution restrictions on these contributions that could restrict a plan participant from converting otherwise eligible pre-tax accounts. Employer match or profit sharing contributions as well as rollover contributions, are often restricted from being distributed until a participant is otherwise eligible to receive a distribution under the more restrictive elective deferral distribution constraints. The reasoning behind this additional restriction is valid: Distributions of accounts prematurely will not only subject the participant to taxes and a potential penalty, but could jeopardize their chances of reaching their retirement goal through the early depletion of some or all of their retirement assets.
Many plan sponsors are anxious to offer this feature in 2010 to take advantage of a special conversion rule that is also afforded to Roth IRA conversions. If pre-tax accounts are converted in 2010, the participant will be able to spread the taxation on the conversion over their 2011 and 2012 tax years. Alternatively, they could elect to pay the tax in full in 2010. This deferral of taxation may be appealing to some individuals, but others may opt instead to pay their tax due on the conversion in 2010 due to the possibility that their tax brackets, which are currently capped at 35%, may spike to 39.6% beginning in 2011. In addition, this is the first year in which many individuals who were previously ineligible to convert can do so. The Tax Increase Prevention and Reconciliation Act of 2005 ("TIPRA") removed the adjusted gross income limitation ($100,000) effective for 2010 so those tax payers who had adjusted gross income above this threshold could finally convert if they chose to do so.
All retirement plan vendors are aware of this new legislation and appear to be acting fast to be able to provide this feature on their platforms before year end. Whether or not they will successful in doing so before year end is yet to be determined. Some of the questions that will need to be addressed before they can implement are:
• Will conversion amounts require separate tracking or will they be included in the employee's Roth deferral account or Roth Rollover account?
• What 1099R code will be used for tax reporting purposes for amounts that are converted?
• Even though only eligible rollover distributions can be converted, will mandatory tax withholding be required on the conversion (presumably no, but stranger things have happened)?
• Will any withholding the participant voluntary elects on the conversion be subject to the 10% early distribution penalty?
Hopefully the retirement community will get the answers they need before year end. If they do, Plan sponsors will need to make sure their plan documents allow for conversions. Some of the Plan provisions that will need to be addressed are:
• Adding Roth contribution arrangement to Plan if currently not available (simply allowing Roth conversions without allowing Roth contributions is not permitted)
• Permitting in service distributions
• Removing distribution restrictions on non-elective type contributions (match, profit sharing), rollover contributions, any voluntary after-tax contributions
• Modifying distribution language if conversions are desirable but the employer does not wish to allow out-of-Plan distributions (amending plan to only allow Roth conversions)
Converting pre-tax accounts to after-tax Roth accounts will most definitely be advantageous to some retirement plan participants. Whether or not converting is right for any one individual though is something that should be researched very wisely as there most certainly could be extreme tax liabilities associated with the conversion.
The information being provided is for general education purposes and with the understanding that it not intended to be used or interpreted as specific legal, tax or investment advice. The scenarios do not address or account for individual investor circumstances. Investment decisions should always be made based on your specific financial needs and objectives, goals, time horizon and risk tolerance. Summit Financial Corporation and its representatives do not provide tax or legal advice to individuals. Consult your tax advisor or attorney regarding specific tax issues.
The materials created through August 2011 are when the professionals of Summit Financial were with Ogilvie Security Advisors Corp. The professionals of Summit Financial have not been with Ogilvie Security Advisors Corp. since August 31, 2011 and have no further affiliation with that organization.