On September 27, 2010, President Obama signed the Small Business Jobs and Credit Act of 2010 (the “Small Business Jobs Act” or the “Act”). The Act provides $12 billion in tax cuts for small businesses and a $30 billion lending fund to improve the availability of credit for small firms. The bill also includes two provisions designed to promote retirement preparation (while raising revenue for the federal government). The first permits Roth contributions to 457(b) plans maintained by state or local governments (a feature that is currently limited to 401(k) and 403(b) plans). The second permits certain amounts in 401(k), 403(b), and governmental 457(b) plans to be converted to Roth accounts within the same plan (i.e., an “in-plan” conversion option). The in-plan Roth conversion option became effective upon enactment, while the Roth 457(b) option takes effect in 2011.
Roth 457(b) Contributions
Under current law, participants in certain tax-favored retirement plans may designate some or all of their elective deferrals as “Roth contributions.” Although Roth contributions are made on an “after-tax” basis, the earnings on those contributions may be received tax-free if the contributions satisfy a five-year holding period requirement and are then distributed in a “qualified distribution.” Like pre-tax employee contributions, Roth contributions count toward the $16,500 annual limit on employee elective deferrals.
Prior to the Small Business Jobs Act, Roth contributions could be made only to 401(k) and 403(b) plans. Beginning on January 1, 2011 (i.e., for taxable years beginning after December 31, 2010), governmental 457(b) plans may also adopt a Roth contribution feature, thereby allowing participants in such plans to designate that some or all of their elective deferrals be treated (and separately accounted for) as after-tax, Roth contributions.
This provision is anticipated to raise $506 million in additional revenue over 10 years. This is because, unlike traditional 457(b) contributions, designated Roth contributions must be included in the participant’s income in the year of the contribution.
In-Plan Roth Conversions
Under current law, the only ways to convert non-Roth retirement savings into Roth savings are to (i) “convert” a traditional IRA into a Roth IRA, or (ii) directly roll non-Roth money from a tax-favored retirement plan (such as a 401(k), 403(b), or governmental 457(b) plan) into a Roth IRA. (The latter option has been available only since January 1, 2008. Such a rollover is treated — for tax purposes — as a non-taxable rollover to a traditional IRA, followed by a taxable conversion to a Roth IRA.)
Prior to 2010, taxpayers whose adjusted gross income (“AGI”) exceeded $100,000 were not permitted to convert a traditional IRA into a Roth IRA. Nor could they roll non-Roth retirement plan amounts into a Roth IRA. This income limitation was eliminated as of January 1, 2010. So regardless of their AGI level, owners of traditional IRAs and participants in tax-qualified retirement plans may roll non-Roth money directly to a Roth IRA, and that rollover will be treated as a taxable “conversion” of pre-tax amounts to after-tax, Roth amounts. If held for the requisite five years and distributed in a “qualified distribution,” those Roth amounts may be received entirely tax-free. 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 is delayed and spread over two years) — unless the participant affirmatively elects to report the entire amount as taxable income for 2010.
Several industry groups expressed concern that the attractiveness of Roth conversions (either through a rollover from a tax-favored plan to a traditional IRA, followed by a conversion to a Roth IRA, or through a direct rollover from a tax-favored plan to a Roth IRA) could result in assets being drained from tax-favored plans. Those industry groups asked for the ability to convert non-Roth amounts held in a tax-favored plan to a Roth account within the same plan. As noted above, this is generally what the new legislation provides.
Under the Small Business Jobs 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, including the following:
- 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, and that plan must include a Roth contribution feature. This means that the in-plan conversion option is not available to money purchase pension plans (which may not allow elective deferrals) or to profit sharing plans that do not include a salary deferral feature. Nor is it available to salary deferral plans that do not allow participants to make designated Roth contributions.
- This conversion option is limited to amounts that are “eligible rollover distributions” (i.e., amounts that are otherwise distributable under the law and the terms of the plan). This means that (i) employee pre-tax deferrals may not be converted prior to separation from service unless the employee has attained age 59 1/2 and the plan permits (or is amended to permit) in-service distributions of such amounts at that age, and (ii) employer contributions (such as matching contributions) may not be converted prior to separation from service unless the plan permits (or is amended to permit) in-service distributions of such amounts on account of an employee’s attainment of a specified age or completion of a specified period of participation.
- The plan must be amended to specifically provide for this option.
The in-plan Roth conversion provision is effective upon enactment (i.e., plans may offer this option on or after September 27, 2010). Because of the special tax rules applicable to 2010 conversions (as well as the uncertainty regarding future tax rates), some participants will be clamoring to make such conversions before the end of 2010. Unfortunately, this does not allow 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).
Generally, plan amendments to reflect “discretionary” 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, amendments to allow 2010 in-plan Roth conversions must generally be adopted by the last day of the 2010 plan year. According to the Act’s legislative history, however, Congress “intends” that the IRS provide plan sponsors with a “remedial amendment period” that will allow them to offer this option during 2010 and still have sufficient time (perhaps even beyond the last day of the 2010 plan year) to amend the plan to reflect the option.
The legislative history also reflects Congress’s intent that plans be allowed to adopt “in-service” distribution provisions that are limited to in-plan conversions. For example, if a plan does not currently allow for distributions of employee pre-tax deferrals until separation from service, the plan could be amended to allow for distributions of such amounts upon attainment of age 59 1/2, but only if the employee rolls those amounts back into a Roth contribution account within the plan (i.e., as an “in-plan” Roth conversion). 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 for many plans. However, this approach does allow plans to increase the amount of “convertible” money without exposing the plan to excessive “leakage.”
Plan sponsors will want 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 types of in-service distributions to in-plan conversions.
Plan sponsors and participants considering an in-plan Roth conversion should also be aware of the differences between post-conversion amounts held in a Roth account within a tax-favored employer retirement plan and similar amounts held in a Roth IRA.
- First, Roth amounts held in a tax-favored plan remain subject to the pre-death “required minimum distribution” rules (which require that distributions begin at the later of age 70 1/2 or retirement), whereas amounts held in a Roth IRA need not be distributed until the IRA owner dies.
- Second, a participant who takes a nonqualified distribution from a Roth IRA is treated as receiving the after-tax contributions (i.e., the participant’s “basis” in the account) before receiving any pre-tax earnings, whereas nonqualified distributions from tax-favored retirement plans are treated as coming proportionately from pre-tax and after-tax amounts (i.e., there is no “basis-first” rule).
- Finally, in the case of a conversion of a traditional IRA to a Roth IRA, a special rule allows the individual to elect to “nullify” the conversion as late as the due date for filing the individual’s tax return for the year in which the conversion occurred (thus allowing the amount to be treated as staying in the traditional IRA). There is no similar rule in the case of an in-plan Roth conversion.
The in-plan Roth conversion feature is estimated to raise $5.1 billion over ten years. This is because individuals who convert pre-tax money to after-tax, Roth contributions must recognize income in the year of the conversion. The only exception is for conversions made during 2010, in which case the taxable income is recognized ratably over 2011 and 2012, unless the participant elects to take the entire amount into income in 2010.
Summary and Recommendations
Employers who currently sponsor 401(k) or 403(b) plans with Roth contribution features will need to decide (almost immediately) whether they wish to allow in-plan Roth conversions and, if so, whether to make that feature available before the end of 2010. These sponsors may also need to decide whether to amend their plans to make additional amounts available for distribution prior to separation from service, and whether those new types of in-service distributions should be limited to in-plan Roth conversions.
Employers who sponsor 401(k) or 403(b) plans that do not currently include a Roth contribution feature (as well as governmental employers that sponsor Section 457(b) plans) may want to consider adding both a Roth contribution feature and an in-plan Roth conversion feature (although these features may not be added to governmental 457(b) plans until 2011).