Phillip Putney
Phillip Putney

Roth Opportunities for 401(k) Participants
Understanding the hurdles to overcome and key differences between in-plan and traditional Roth IRA conversions.

January 20, 2011
by Phillip Putney, CPA, PFS

To Roth or not to Roth has been the question for many individual retirement account (IRA) owners during 2010 with the easing of the Roth conversion rules and the additional incentive allowing the conversion income to be spread over 2011 and 2012. However, 401(k) participants have faced many additional challenges in converting their retirement funds to a Roth. Until the Small Business Jobs Act of 2010 (SBJA) was signed into law on September 27, 2010, the only way a participant could convert their traditional 401(k) was to take a distribution and roll it into a Roth IRA. The SBJA corrected this by allowing in-plan conversions; however, there are three hurdles that the participants must overcome to use this conversion method:

1. The plan must offer a Roth 401(k) option known as a designated Roth account. The Roth 401(k) option was created by the Economic Growth and Tax Relief Act (EGTRRA) of 2001, but didn’t become effective until January 1, 2006. When first introduced, few plan sponsors opted to include this option into their plans as EGTRRA also eliminated it after 2010. However, the 2006 Pension Protection Act (PPA) made the option permanent, thus making it more appealing to plan sponsors.

2. The plan must allow in-plan conversions. The SBJA introduced this feature, which allows the conversion from non-Roth plan assets to designated Roth accounts maintained in the plan; however, it does not require the plan to adopt the provision. Even if the plan decided to adopt the provision, there was a very short window for 2010 conversions since the SBJA became effective when signed into law on September 27, 2010. The one bright spot is that the SBJA does allow participants to act on this provision when their plan decides to add it, provided the plan is amended to reflect the change by the later of the last day of the plan year for which the amendment becomes effective or December 31, 2011.

3. The participant be eligible for a distribution under the plan.

While hurdles one and two are fairly straight forward and as long as the participant’s plan has a Roth provision and allows in-plan conversions, it would seem that the provisions would be available to everyone, it is the third hurdle that will probably prevent most in-plan conversions.

Two of the most common distribution provisions that will allow in-plan conversions are separation from service and in-service distributions. Separation from service is fairly simple, but begs the question as to whether a participant should convert within the plan or simply take a distribution and convert to a Roth IRA.

In-service Distribution Provision

For participants wanting to make in-plan Roth conversions using the in-service distribution provision, there are a whole new set of challenges:

1. The plan must allow in-service distributions; not all plans do nor are they required to.

2. If the participant is under age 59½, they are only eligible to convert the plan sponsor contributed funds (i.e. matching or profit sharing contributions) as their elective deferrals are not eligible for distribution under the Internal Revenue Code (IRC) until their death, disability, separation from service or age 59½.

3. The participant can only convert the vested portion of the plan sponsor contributions, further limiting the potential conversion amount.

This third and most restrictive hurdle can be overcome to some extent by the plan as explained in IRS Notice 2010-84. This notice allows a plan to be amended to add an in-plan Roth direct rollover option for amounts that are permitted to be distributed under the IRC, but that may not have been distributable under the more restrictive terms contained in the plan.

Regardless as to how a participant gains access to the funds, if they can convert them at the plan level, they can generally take a distribution and convert them into a Roth IRA. That then begs the question of what is more advantageous for the participant, an in-plan conversion to a designated Roth account or a distribution and subsequent conversion to a Roth IRA. To answer this question, we will look at four key differences between a designated Roth account and a Roth IRA.

Roth Account vs. Roth IRA

The first and probably the most detrimental difference is the ability to re-characterize the conversion. Currently, there is no mechanism in place to re-characterize a Roth conversion made via an in-plan conversion to a designated Roth account. The re-characterization rules of IRC section 408A(d)(6) only apply to contributions to an IRA and the SBJA that introduced the in-plan conversion provision is silent on the issue. So, it seems that absent additional legislation from Congress or regulations from the IRS, conversions to designated Roth accounts are irrevocable.

One of the most cited reasons people make Roth conversions is to avoid required minimum distributions (RMDs), so the second difference relating to RMD requirements could also affect their decision on which conversion method to use. It is well understood that Roth IRAs don’t have RMDs during the owner’s lifetime; however, this is not the case for funds held in designated Roth accounts of a 401(k). Unless the participant is still working for the plan sponsor, they must take RMDs from their designated Roth account starting at age 70 ½. The participant could of course get around this requirement by rolling over the designated Roth account to a Roth IRA before this time, but why not convert to a Roth IRA to begin with?

The third difference relates to the five-year clock. When an individual establishes their first Roth IRA, the five-year clock starts running and is shared by all of the individual’s Roth IRAs. Once the individual reaches age 59 ½ and has held any Roth IRA for at least five years, all future distributions from any of the individuals Roth IRAs are tax and penalty free. The same cannot be said about designated Roth accounts as each plan has its own five-year clock. Therefore, if an individual has multiple designated Roth accounts, they will have to keep track of each plan’s five-year clock separately.

The last difference relates to creditor protection and is perhaps the biggest reason to convert at the plan level. Funds held in 401(k)s are covered under the federal creditor protection rules of ERISA whereas creditor protection for IRAs is based on state law. In some states, the creditor protection allowed for IRAs is comparable to that allowed for 401(k)s; however, other states only offer reduced levels of protection if any at all.


To Roth or not to Roth for a 401(k) participant isn’t a question of just the potential tax savings as it is for many IRA owners. A 401(k) participant must first determine if they can even overcome the hurdles that will allow a Roth conversion. If these hurdles can been overcome, they then need to determine whether the conversion should be done at the plan level as now allowed by the SBJA or done through a more traditional method with a conversion to a Roth IRA. As their trusted advisor, your clients will undoubtedly need your assistance in this decision to avoid the many potential traps that lie wait.

 Rate this article 5 (excellent) to 1 (poor). Send your responses here.

Phillip P. Putney, CPA, MST, PFS is a certified public account, financial advisor and owner of Advanced Financial Solutions, LLC a financial advisory firm in Farmington Hills, MI specializing in tax efficient retirement and distribution planning. Securities and Advisory Services offered through Centaurus Financial, Inc. a Registered Broker Dealer and Registered Investment Advisor, member FINRA/SIPC.