Recent IRS guidance has resolved significant questions about the administrative and reporting requirements for in-plan Roth conversions. Plan sponsors who put off adding this feature to their plans (or taking advantage of additional options authorized by Congress in 2013) may wish to consider adding or expanding it now.
As part of the Small Business Jobs Act of 2010 (“SBJA”), Congress amended the Tax Code to allow plans with Roth contribution features to give participants the option of rolling over amounts other than Roth contributions to their Roth accounts under the plan. Participants are taxed on such in-plan conversions in the year of the rollover as if the amount had been distributed to them, and when the converted amounts eventually are distributed (provided the Code’s requirements are satisfied), both the amount rolled over and any associated earnings are distributed tax-free. Later in 2010, the IRS issued Notice 2010-84, clarifying the mechanics of such conversions and providing other related guidance. (For a detailed discussion of that guidance, see our February 2011 article.)
The in-plan Roth conversions created by SBJA were restricted to amounts that were already distributable under the Code. However, as part of the American Taxpayer Relief Act of 2012 (“ATRA”), Congress expanded the types of contributions eligible for in-plan conversion to include amounts that were not otherwise distributable under the Code, thereby greatly increasing the funds available for conversion.
But ATRA’s expansion of the in-plan rollover option left enough unanswered questions regarding the administration of the new options that many plan sponsors delayed implementation of the new features—sometimes because their recordkeepers declined to offer the necessary services until the IRS provided further guidance. In Notice 2013-74, the IRS has resolved not only many of the new questions raised by the ATRA changes, but also lingering questions regarding the rules governing the original in-plan Roth conversion option added by SBJA. This article summarizes key points of this new guidance.
Perhaps the most significant question answered in the Notice is that, following the conversion of amounts that are not otherwise distributable, the resulting Roth amounts remain subject to the same distribution restrictions that applied to those amounts before the conversion. Thus, for example, if a 401(k)-plan participant who remains employed with the plan sponsor converts her pre-tax deferrals, that amount and any associated earnings may not be distributed before she is eligible for a distribution of pre-tax deferrals (i.e., before she attains age 59½, terminates her employment, dies, or is disabled, or the plan is terminated).
The upshot of this requirement is that any amount converted under the new ATRA rules (i.e., any amount that is not otherwise distributable) must be accounted for separately from other Roth amounts (converted or otherwise) that are distributable.
TRA’s expanded Roth conversion rules apply to Section 401(k) plans, Section 403(b) plans, and governmental Section 457(b) plans that include Roth contribution arrangements.
Under ATRA’s liberalized in-plan conversion rules, the following contribution types are eligible for conversion, regardless of whether they are otherwise distributable from the plan: pre-tax elective deferrals to Section 401(k) plans and Section 403(b) plans; matching contributions and nonelective contributions, including qualified matching contributions (“QMACs”) and qualified non-elective contributions (“QNECs”); and all amounts deferred under governmental Section 457(b) plans (whether attributable to salary deferrals or employer contributions). In all cases, such contributions must be vested to be eligible for conversion.
Amendments and Deadlines
According to the Notice, an amendment adding or expanding an in-plan Roth conversion feature is a discretionary amendment that must be adopted by the end of the plan year in which it becomes effective. However, the Notice provides an extended deadline for sponsors of Section 401(k) and Section 457(b) plans that began offering conversion of otherwise nondistributable amounts in 2013. This remedial amendment period ends December 31, 2014.
The Notice also permits safe-harbor 401(k) plans to be amended to add the expanded in-plan conversion rules as late as December 31, 2014, without violating the prohibition on mid-year changes to such plans. After 2014, however, a safe-harbor plan will not be able to add a conversion feature during the course of a plan year.
Section 403(b) plans must be amended by the last day of the plan year in which the in-plan rollover feature is effective, or the end of the remedial amendment period for written 403(b) plans. (The IRS has not yet announced the end of this remedial amendment period, but the Notice states that it will be more than a year after the IRS announces that deadline.)
The contribution types added by ATRA’s expansion of the in-plan conversion rules are, by definition, not distributable from the plan even after they are rolled over. Accordingly, the Notice states that the Section 402(f) Notice (the “special tax notice”) that is ordinarily required before distribution of an eligible rollover amount is not required for a participant making an in-plan conversion of an otherwise nondistributable amount.
Because in-plan Roth conversions of otherwise nondistributable amounts must be made by way of a direct rollover, no withholding is required. Moreover, because the amount is not distributable (even after the conversion), no part of the converted amount may be voluntarily withheld under Code Section 3402(p). Thus, the participant may not use part of the converted amount to pay taxes on the conversion.
(Although the IRS has not yet specifically stated whether participants may elect voluntary withholding in order to pay taxes on a conversion of otherwise distributable amounts, a distributee and a plan administrator are permitted to enter into a voluntary withholding agreement with respect to direct rollovers to a Roth IRA. Thus, most practitioners believe that such agreements are likewise permissible with respect to in-plan conversions of otherwise distributable amounts.)
Net Unrealized Appreciation
The Notice explains that any in-plan Roth conversion (whether or not the amount is distributable) is treated as a distribution for purposes of determining eligibility for the special tax treatment that applies to net unrealized appreciation (“NUA”) in employer securities. Thus, if employer stock is rolled over to a Roth account (regardless of whether it was distributable at the time of conversion), that stock will no longer be eligible for favorable NUA treatment.
No Anti-Cutback Concerns
According to the Notice, an in-plan Roth conversion feature is not a protected benefit under the Code’s anti-cutback rules. Thus, plan sponsors may choose to experiment with this feature, and then delete it later without violating the anti-cutback rules. (However, the timing of any amendment to add or eliminate an in-plan Roth conversion feature is subject to the Code’s non-discrimination rules. Thus, if the timing of such an amendment has the effect of discriminating in favor of highly compensated employees, it may violate those rules.)
Now that the IRS has resolved these key questions about in-plan Roth conversions, sponsors who have so far passed on the opportunity may wish to add this feature to their plans. Sponsors who already offer in-plan conversions may now wish to take advantage of the new options added by ATRA. Contact any member of Spencer Fane’s Employee Benefits Group for more information about adding or expanding an in-plan Roth conversion feature.