On September 27, 2010, President Obama signed the Small Business Jobs and Credit Act of 2010 (the “Act”), which includes two provisions designed to promote retirement preparation (while raising revenue for the federal government). The first would permit Roth contributions to Section 457(b) plans maintained by state or local governments (a feature that is currently limited to 401(k) and 403(b) plans). The second would permit certain amounts in 401(k), 403(b) and governmental 457(b) plans to be converted to Roth accounts within the plan (i.e., an “in-plan” conversion option).
Roth 457(b) Contributions
Under current law, participants in certain tax-qualified plans may designate their elective contributions as “Roth contributions.” Although Roth contributions are made on an “after-tax” basis, if the contributions satisfy a five-year holding period requirement and are distributed in a “qualified distribution,” the earnings on such contributions are tax-free.
Prior to the Act, Roth contributions were available only in 401(k) plans and 403(b) arrangements. Beginning January 1, 2011, however, governmental 457(b) plans may also adopt a Roth contribution feature. This will allow participants in such plans to elect that some or all of their deferrals be treated (and separately accounted for) as after-tax, Roth contributions.
Roth IRA Conversions
Prior to the Act, the only way to change non-Roth retirement savings into Roth savings was to either (i) “convert” a traditional IRA into a Roth IRA, or (ii) roll non-Roth money from a tax-favored retirement plan (such as a 401(k), 403(b) or governmental 457(b) plan) directly to a Roth IRA. However, prior to 2010, taxpayers whose adjusted gross income (“AGI”) exceeded $100,000 were not permitted to make an IRA conversion or to roll non-Roth retirement plan amounts into a Roth IRA.
Effective in 2010, that income limitation was eliminated. Beginning this year, regardless of their AGI, traditional IRA owners and participants in tax-qualified retirement plans may roll non-Roth money directly to a Roth IRA, and the rollover will be treated as a taxable “conversion” of pre-tax amounts to after-tax Roth amounts. Moreover, under a special rule, amounts that are converted during 2010 will be taxed ratably over two years, starting in 2011 (i.e., the income recognition will be delayed and spread over two years) – unless the participant affirmatively elects to report the entire amount as taxable income in 2010.
In-Plan Roth Conversions
Under the Act, participants in a tax-favored plan that has a Roth contribution feature may “roll” non-Roth amounts to a designated Roth account maintained within the same plan, and this “rollover” will be treated as a taxable conversion. However, there are some significant limitations on this “in-plan conversion” option.
- The plan offering the in-plan conversion option must be a 401(k) plan, a 403(b) plan, or (on or after January 1, 2011) a governmental 457(b) plan that includes a Roth contribution feature.
- The in-plan conversion option is limited to amounts that are otherwise “distributable” under the Tax Code and under the terms of the plan. This means that (1) employee pre-tax contributions may not be converted prior to separation from service unless the individual has attained age 59½ and the plan permits (or is amended to permit) the in-service distribution of such amounts at that age, and (2) employer contributions (such as matching contributions) cannot be converted prior to separation from service unless the plan permits (or is amended to permit) the in-service distribution of such amounts on account of the attainment of a specified age or number of years of participation.
- The plan must be amended to specifically provide for Roth conversions.
The in-plan Roth conversion provision is effective immediately (i.e., plans may offer this option on or after September 27, 2010). However, that does not provide much time for plan sponsors to adopt plan amendments and draft appropriate participant communications (or for service providers to prepare to record keep and/or report such conversions). Because of the special tax rules applicable to 2010 conversions (as well as the uncertainty regarding future tax rates), participants may be clamoring to make such conversions before the end of the 2010 plan year.
Adding an In-Plan Roth Conversion Feature
Generally, plan amendments to reflect “optional” law changes (such as the in-plan Roth conversion option) must be adopted by the last day of the plan year in which the optional provision is first made effective. Thus, plan amendments to allow 2010 in-plan Roth conversions must generally be adopted by the last day of the 2010 plan year. However, according to the legislative history of the Act, Congress “intends” for the IRS to provide plan sponsors with a “remedial amendment period” that will allow sponsors to offer this conversion option in 2010, but with sufficient time (perhaps even beyond the last day of the 2010 plan year) to amend the plan to reflect the option.
The legislative history of the Act also indicates that it is Congress’ intent that plans may adopt “in-service” distribution provisions that are limited to in-plan conversions. For example, if a plan currently does not allow distributions of employee pre-tax contributions until separation from service, the plan could be amended to allow the distribution of such amounts upon attainment of age 59½, but only if the participant “converts” those amounts into Roth contributions within the plan (such that the money never actually leaves the plan).
Although this ability to restrict certain distributions to in-plan conversions is generally limited to new in-service distribution provisions (because imposing such a restriction on an existing in-service distribution feature would be an impermissible cut-back), this does allow plans to increase the amount of “convertible” money without exposing the plan to excessive “leakage.” Plan sponsors will need to watch for future guidance from the IRS regarding (i) when plans must be amended to reflect an in-plan conversion option that is effective in 2010, and (ii) the legality of limiting new in-service distributions to in-plan conversions.
Open Issues for Plan Sponsors (and Service Providers)
Although certain plan participants may wish to make in-plan Roth conversions before the end of 2010 (either to take advantage of the special rule that allows the participant to spread the income over a two-year period beginning in 2011, or simply to recognize the income before tax rates increase), there are many open issues for plan sponsors (and service providers) who are considering adding this feature to their plans. The “open questions” include:
- Will the IRS actually provide (as suggested by Congress) a “remedial amendment period” for adopting plan amendments (such that the plan does not have to be amended by the last day of 2010 to allow 2010 conversions)? If so, will that additional time also apply to amendments to add a Roth contribution feature in the first place, or to add additional in-service distribution options?
- Will the IRS actually allow plans to make additional amounts available for in-plan conversion only (but not for “distribution” from the plan), and if so, must an amendment be adopted before the plan allows such conversions (or will these types of amendments also be covered by the “remedial amendment period” discussed above)?
- Must the employer “withhold” on this taxable conversion? (Most commentators believe the answer is no, but confirmation would be helpful.)
- Must the plan report the distribution on Form 1099, and if so, how must it be coded? (Again, most commentators are assuming that the answer is yes, although there is less certainty regarding the proper code to report the conversion.)
- Must the converted amounts (and the earnings thereon) be held in a separate account from designated Roth contributions? (Most commentators believe the answer is yes, for a variety of reasons.)
- What steps must be taken to “complete” an in-plan conversion before the end of 2010 (i.e., is it sufficient for the participant to make a written election, or must some additional steps be taken by the plan or the plan’s service provider to demonstrate that the amounts have actually been “converted” to after-tax, Roth amounts)?
- Are there separate five-year holding periods for designated Roth contributions and converted amounts?
- If a plan requires spousal consent to distributions and/or loans, must it also require spousal consent to an in-plan Roth conversion?
- Can the portion of a participant’s account that is a participant loan (i.e., a promissory note) be converted?
Employers who currently sponsor 401(k) or 403(b) plans with Roth contribution features will need to decide (very soon) whether they wish to allow in-plan Roth conversions, and if so, whether they wish to make that feature available before the end of 2010. In addition, those same plan sponsors will need to decide whether they wish to amend their plans to make additional amounts available prior to separation from service, and whether those new in-service distribution options should be limited to in-plan Roth conversions. Part of the decision-making may depend on whether (and when) the plan’s administrator/recordkeeper will be able to accommodate such conversions.
Finally, employers who sponsor 401(k) or 403(b) plans that do not currently include a Roth contribution feature (as well as sponsors of governmental 457(b) plans) may want to consider adding both a Roth contribution feature and an in-plan Roth conversion feature (although governmental 457(b) plans cannot add those features until 2011).