Congress and the IRS are encouraging individuals to convert their retirement savings into Roth accounts (as a means to increase revenue). Pursuant to changes to the Tax Code made by the Small Business Jobs Act of 2010 (“SBJA 2010”), sponsors of Section 401(k) plans, Section 403(b) plans, and governmental Section 457(b) plans may now allow participants to convert their pre-tax accounts into Roth accounts. And on November 26, 2010, the IRS issued Notice 2010-84 (the “Notice”), clarifying the mechanics of such conversions and providing timing relief for the necessary plan amendments. This article briefly summarizes the basics of Roth contributions, and then examines highlights of the statutory changes and the recent IRS guidance regarding conversions.Designated Roth Contributions
If a Section 401(k), 403(b), or 457(b) plan has a “qualified Roth contribution program,” participants may make Roth contributions in lieu of the pre-tax deferrals they might otherwise make. These contribution types differ in that (i) Roth contributions do not reduce the participant’s taxable income, and (ii) distributions of Roth contributions are exempt from federal income tax, provided the distribution is “qualified.” Roth contributions also differ from ordinary after-tax contributions, in that distributed earnings on Roth contributions are also tax-free—again, so long as the distribution is “qualified.” Qualified Roth Distributions. A distribution of Roth contributions is qualified only if it is made after (i) the participant attains age 59½, becomes disabled, or dies; and (ii) a five-year waiting period is complete. This five-year period consists of five consecutive years beginning with January 1 of the first calendar year in which the participant made designated Roth contributions to the Plan. (In the case of Roth contributions that are rolled over from one plan to another, the period beings on January 1 of the first calendar year in which the participant made a designated Roth contribution to the first plan.) If a distribution is not qualified, the portion attributable to earnings on Roth contributions will be included in the participant’s income for federal income tax purposes. In addition, the amount attributable to such earnings will also be subject to the 10% penalty tax for early distributions, unless an exception applies. Characteristics of Roth Contributions. Aside from their special tax treatment, Roth contributions are, for most purposes, treated like elective deferrals. For example:
- They are subject to the same distribution restrictions (attainment of age 59½, termination of employment, disability, and death);
- Because Roth contributions are made in lieu of the pre-tax elective deferrals a participant could otherwise make, the same annual limits apply—each dollar of Roth contributions the participant makes for a year therefore reduces by one dollar the amount of pre-tax deferrals he or she can make for the year;
- Catch-up contributions may be designated as Roth contributions;
- Roth contributions are included in the plan’s ADP testing;
- They may be the basis for a participant loan; and
- In a plan that features an automatic contribution arrangement, some or all automatic deferrals may be designated as Roth contributions, if the plan so provides.
In-plan Roth conversions are an optional feature of any plan that includes a qualified Roth contribution program. This feature allows participants to “roll over” any eligible rollover distribution of non-Roth amounts to a separate Roth account under the same plan. Before SBJA 2010 changed the Tax Code, participants could make such a conversion only by rolling the distribution out of the plan to a Roth IRA.
An in-plan conversion can be accomplished by either a direct rollover or a “60-day” rollover. In either case, the conversion is taxable as if the amount were distributed to the participant, although it is exempt from the 10% early withdrawal penalty that would otherwise apply. Any plan that includes a qualified Roth contribution program may offer the in-plan conversion option. Any active or former participant may take advantage of it, as may surviving spouses of participants and alternate payees who are either the spouse or former spouse of a participant.
Requirements Qualified Roth Contribution Program Must Be in Place. Only plans that have a qualified Roth contribution program in place may offer in-plan conversions. According to the Notice, a qualified Roth contribution program is “in place” when participants have the right to make designated Roth contributions. In other words, a plan cannot be amended to add in-plan conversions without also allowing participants to designate new deferrals as Roth contributions. Eligible Rollover Distribution. To be converted, an amount must be an “eligible rollover distribution.” Accordingly, the amount must be distributable under both the terms of the plan and the Code, and it cannot be a required minimum distribution, a hardship distribution, an annuity distribution, or any of the other ineligible distributions listed in IRS Publication 590. As explained more fully below, this requirement presents significant design flexibility for sponsors who are considering adding an in-plan conversion feature. The following contribution types cannot be distributed (and therefore cannot be eligible rollover distributions) until the participant has either attained age 59½, become disabled, terminated employment, or become eligible for a qualified reservist distribution:
- Pre-tax elective deferrals to 401(k) and 403(b) plans;
- Qualified nonelective contributions (“QNECs”);
- Qualified matching contributions (“QMACs”); and
- Employer contributions to 403(b)(7) custodial accounts.
Accordingly, these amounts cannot be converted in an in-plan Roth conversion until one of the specified events occurs—even though they would remain in the plan.
But other contribution types may be distributed sooner, depending on the terms of the plan. For example, rollover and after-tax contributions may be distributed (and therefore converted) at any time.
Most importantly, however, vested employer matching and profit-sharing contributions to 401(k) plans and 403(b) annuities may be distributed upon the attainment of a “specified age” or the occurrence of a “specified event.” IRS guidelines for these “age and event” distribution triggers are not terribly helpful. They are described in some dated regulations and Revenue Rulings, and the IRS has steadfastly declined to clarify them.
Given the lack of clear guidance, some plan sponsors have been aggressive, making the “age” trigger for an in-service distribution the attainment of the plan’s minimum participation age (usually 18 or 21). This has the effect of making all vested matching and nonelective contributions distributable (and therefore convertible) at any time. Limiting such in-service distributions to participants who have attained at least age 50 is clearly more defensible; but until the IRS issues clearer guidance, we cannot say that “age-related” distributions to younger participants are clearly impermissible.
The “specified event” trigger is slightly clearer because the IRS has provided two examples of events that will satisfy it. These are (i) the participant’s completion of five years of participation in the plan, and (ii) “seasoning” of the amount to be distributed by virtue of its being held in the plan for at least two years.
New Distribution Options May Be Limited to In-Plan Conversions. SBJA 2010 and the Notice permit sponsors to add new distribution options that are available only for in-plan conversions. Sponsors may therefore apply the “age and event” triggers to craft new distribution options that expand participants’ rights to convert their accounts to Roth accounts without allowing the money to leave the plan.
For example, a plan that allows in-service distributions at age 65 could allow in-plan conversions (of elective deferrals or employer contributions) between ages 59½ and 65, without allowing “real” distributions during that period. Or a plan that does not allow in-service distributions at all could allow in-plan conversions (only) of employer contributions for individuals with five years of participation, or with respect to amounts that had been held in the plan for at least two years. However, existing in-service distribution options cannot be restricted to in-plan Roth rollovers. Such an amendment would violate the Code’s anti-cutback rule.
Before participants may elect an in-plan Roth conversion, the plan must include (i) a qualified Roth contribution program, (ii) provisions allowing in-plan conversions, and (iii) a distribution option that allows the amounts to be converted. Typically, an amendment adding such features would have to be adopted before the end of the plan year in which they take effect, or even earlier. In the Notice, however, the IRS has provided extended amendment deadlines for the following changes:
- Adding a qualified Roth contribution program;
- Adding an in-plan Roth conversion feature;
- Adding distribution options; and
- Adding distribution options linked to in-plan conversions.
It is not permissible, however, to retroactively amend a plan to add a pre-tax deferral feature. Thus, for example, the extended deadlines are not available for a qualified plan if the plan does not already provide a 401(k) feature. The extended amendment deadlines are as follows:
- For 401(k) plans, the later of: (i) the last day of the first plan year in which the amendment is effective, or (ii) December 31, 2011.
- For safe-harbor 401(k) plans, the later of: (i) the day before the first day of the first plan year in which the amendment is effective, or (ii) December 31, 2011.
- For 403(b) plans, the later of: (i) the end of the plan’s remedial amendment period (if any), or (ii) the last day of the first plan year in which the amendment is effective.
- For 457(b) plans: we are still awaiting IRS guidance.
Thus, for example, a “generic” (i.e., calendar-year, non-safe-harbor) 401(k) plan may administratively establish a qualified Roth contribution program and provide for in-plan conversions anytime during 2011, so long as it is amended accordingly no later than December 31, 2011.Exceptions to Treatment as Distributions
For tax purposes, an in-plan Roth conversion is treated as a distribution. For most other purposes, however, in-plan conversions are not treated as distributions. Thus, for example:
- If a participant’s account includes an outstanding plan loan, the repayment schedule of the loan will remain the same;
- Spousal consent is not required for an in-plan conversion;
- The rolled-over amount is taken into account in determining whether the participant must consent to a distribution (instead of being cashed out); and
- The converted amount is also taken into consideration when determining whether the participant is eligible for an optional form of payment (such as an annuity).
If a plan includes an in-plan conversion feature, the Section 402(f) “Special Tax Notice” sent to participants must describe that feature. Thus, plan sponsors who add an in-plan conversion feature will also need to update their Special Tax Notices.
Designated Roth contributions must be accounted for separately from other contributions. Converted amounts must also be accounted for separately, even from designated Roth contributions. This is because subsequent distributions must differentiate (for reporting purposes) between designated Roth contributions (and associated earnings) and converted amounts. In addition, designated Roth contributions are generally subject to withdrawal restrictions that cannot be applied to converted amounts (which, by definition, are already eligible rollover distributions).
Beginning with 2011, in-plan Roth conversions are taxable in the year of conversion. (A special rule applied to in-plan conversions made during 2010.) The participant is taxed on the fair market value of the distribution, less any basis. There is no 20% mandatory withholding from a conversion made as a direct rollover. Instead, the participant is responsible for any estimated tax reporting and payment. If the participant leaves the converted amount in the plan for five calendar years (counting the year of conversion), there will be no 10% early distribution penalty.
The “payor” of the conversion (typically, the plan’s recordkeeper) must report the conversion on a Form 1099-R for the year of conversion. The converted amount must be included in Box 1, and the taxable amount of the conversion must be included in Box 2a. The participant’s basis in the distribution must be reported in Box 5, and Code “G” should be checked in Box 7.
What Should Plan Sponsors Do?
SBJA 2010 encourages Roth conversions in at least three ways. For participants, it simplifies the process by eliminating the extra step of distributing the amounts to a Roth IRA. It also allows them to take advantage of the plan’s familiar administrative procedures and investment options. In many cases, the plan’s size and the employer’s bargaining power will also result in lower administrative fees than the participant could obtain from an IRA custodian. Many participants—particularly those who take an active interest in tax planning—will therefore be interested in the in-plan conversion option. For sponsors, in-plan conversions offer a means of keeping converted amounts in the plan, rather than distributing them to the participant or an IRA custodian.
If a plan sponsor decides to add an in-plan Roth conversion feature, the option must be communicated to all participants through an updated summary plan description or a summary of material modifications. As noted above, the sponsor must also revise its Section 402(f) Special Tax Notice to explain the tax treatment of converted amounts. (The IRS has provided sample language in the Notice.)
Thus, plan sponsors interested in adding an in-plan conversion feature should take the following steps:
- Consider whether an in-plan conversion feature is right for their 401(k), 403(b) or governmental 457(b) plan;
- Consider whether new distribution options should be added to the plan, and if so, what the triggers should be;
- Communicate with their recordkeeper about implementing the new feature;
- Prepare the necessary plan amendments;
- Prepare and distribute the necessary participant communications explaining the new feature;
- Prepare revised Special Tax Notices; and
- Update their administrative procedures.
Spencer Fane’s Benefits Group would be pleased to assist with each step of this process.