In-Plan Roth Conversions: Planning and Administrative Considerations
New option is not always the best course.
Before enactment of the Small Business Jobs Act of 2010 (SBJA), amounts held in section 401(k), 403(b) and 457(b) plans could be converted to a Roth-type retirement plan only by taking a distribution and rolling it into a Roth IRA. This put plan sponsors in a difficult position, because in-service distributions can be made only to the extent permitted under the plan document. If distribution options were expanded to increase the amounts that could be rolled over, participants might use distributions for purposes other than Roth conversions.
To solve this problem, the SBJA, signed into law in September 2010, included a provision (IRC § 402A(c)(4)) allowing in-plan conversions of amounts held in 401(k), 403(b) and 457(b) plans to Roth accounts and permitting plans to be amended to create a new distribution option solely for in-plan Roth conversions (IPRCs). Generally, an in-plan Roth conversion is available only to participants in eligible qualified plans who have separated from service, have died, are disabled or are age 59½ or older. An additional category of eligible rollover is a “qualified reservist distribution.”
The SBJA did not address the nuts and bolts of the new option, however, leaving a number of questions unanswered. On Nov. 26, 2010, the IRS issued Notice 2010-84 (PDF) providing detailed IPRC guidance in a question-and-answer (Q&A) format. This article summarizes the guidance, discusses tax treatment of the conversion and describes why, for most taxpayers, a conversion to a Roth IRA is likely to remain a more favorable option than an IPRC.
Notice 2010-84 Guidance
Effective Sept. 28, 2010, section 401(k) and 403(b) plans may permit qualifying participants to convert their accounts to Roth accounts in the same plan. Effective Jan. 1, 2011, section 457(b) plans (government plans) have the same option. The conversion can be accomplished either by a direct rollover to the Roth account or by a distribution of funds to the individual, who then rolls over the funds into his or her designated Roth account in the plan within 60 days.
Persons eligible to make an IPRC. A rollover election can be made not only by a plan participant but also by a surviving spouse beneficiary or by an alternate payee who is a spouse or former spouse (Notice 2010-84, Q&A 14).
Amounts eligible for conversion. Amounts can be eligible for conversion only if they meet both Code and plan requirements, specifically:
A plan can be amended to add an IPRC option for amounts that are permitted to be distributed under the Code but could not be distributed under the plan’s more restrictive terms. As noted above, the amendment does not need to permit any other rollover or distribution option for these amounts that would cause “leakage” of plan assets (Q&A 4).
Besides the restrictions on eligible participants’ age and status noted above, amounts that would not qualify for a rollover to another eligible retirement plan do not qualify for an IPRC. These include required minimum distributions (RMDs), hardship distributions, corrective distributions of excess deferrals, dividends from employer securities and deemed distributions (Q&A 2).
IPRC treated as a plan distribution for limited purposes. Treating the IPRC as a distribution for all purposes of the Code would produce unwanted tax consequences. Thus, Notice 2010-84 makes it clear that an IPRC is treated as a distribution only for the limited purpose of treating amounts as includable in a Roth account. This means that:
The taxable amount for an IPRC is the same amount that would be included in gross income if the rollover were made to a Roth IRA. This amount is the fair market value of the distribution, including net unrealized appreciation minus any basis the taxpayer has in the distribution from after-tax contributions (Notice 2009-75).
This taxable amount is included in income for the year of the conversion, except optionally for conversions in tax years beginning in 2010, when a taxpayer could choose between including the full taxable amount in income in 2010 or making half the amount taxable in 2011 and half in 2012. If the taxpayer elected to recognize all the income in 2010, the election cannot be changed after the due date (with extensions) for filing the taxpayer’s 2010 income tax return. To be eligible for the two-year deferral period, the IPRC distribution must have been made no later than Dec. 31, 2010 (Q&A 19).
This article has been excerpted from the Journal of Accountancy. View the full article here.