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Fiscal Cliff Legislation Includes Expansion of In-Plan Roth Conversions

On January 1, 2013, Congress passed the American Taxpayer Relief Act of 2012 (“ATRA”), thereby preserving and making permanent (for taxpayers other than individuals making over $400,000 per year or couples making over $450,000 per year) the Bush-era tax rates that would otherwise have expired in 2013. ATRA also provides a permanent “patch” on the alternative minimum tax (“AMT”), preservation of the current $5 million estate tax exemption amount (which was also to sunset after 2012), a small increase in the maximum estate tax rate (from 35 to 40%), and a host of other provisions.

One of the few revenue generators in the legislation is an amendment to the Tax Code that expands the availability of “in-plan Roth conversions” in employer-sponsored retirement plans. Since 2006, Section 401(k) plans and Section 403(b) plans have been permitted (but not required) to allow participants to designate certain employee contributions as after-tax Roth contributions rather than pre-tax elective deferrals. Designated Roth contributions are taxed much like Roth IRA contributions: the contributions are taxable in the year made, but if the contributions remain in the plan for the requisite 5-year holding period and are withdrawn after age 59½ (or on account of death or disability), there is no tax on the contributions or the earnings on such contributions when they are distributed to the participant.

In 2010, the Small Business Jobs Act (“SBJA”) extended the availability of Roth contributions to Section 457(b) eligible deferred compensation plans maintained by governmental employers. The SBJA also allowed participants in 401(k), 403(b) and 457(b) plans to convert certain pre-tax amounts held in the plan to after-tax Roth amounts, through a taxable “in-plan Roth conversion.” However, in-plan Roth conversions under the SBJA were limited to amounts that were otherwise “distributable” under the tax laws. Thus, for example, an active employee could not convert pre-tax elective deferrals to Roth amounts prior to attaining age 59½.

Under ATRA, 401(k), 403(b) and governmental 457(b) plans that include a Roth contribution feature may now offer employees the option of converting any pre-tax amounts held in the plan, including elective deferrals, to after-tax Roth amounts in a taxable “in-plan Roth conversion,” regardless of whether such amounts are otherwise “distributable” under the Tax Code. This will greatly expand the potential for taxable conversions of pre-tax amounts to Roth amounts, although it remains to be seen whether this option will in fact generate the amount of tax revenue ($12 billion over the next 10 years) that Congress anticipated when “scoring” the legislation.

Like the SBJA in-plan Roth conversion provision, the new rule is optional, not mandatory, and will therefore require a plan amendment. The statutory change is effective immediately, but plans that intend to implement the new rule right away will likely need to amend their plans before the end of the 2013 plan year.

The participants who are most likely to benefit from this expansion of the in-plan Roth conversion feature are (i) younger employees who are still in relatively low income tax brackets, (ii) employees under age 59½ with significant pre-tax account balances who wish to diversify the taxability of their retirement portfolio, and (iii) employees who have sufficient funds outside of their retirement plan to pay the taxes due on the conversion.

Any employer interested in adding an in-plan Roth conversion feature to a 401(k), 403(b), or governmental 457(b) plan (or modifying an existing provision as permitted under this new legislation) should feel free to contact any member of Spencer Fane’s Employee Benefits Practice Group.