To Be Taxed Now or Taxed Later? New Law Permits In-Plan Roth Conversion

October 2010Newsletters For Your Benefit

On September 27, 2010, President Obama signed into law the Small Business Jobs Act of 2010. Included in the law is a small revenue-raising provision that allows participants to convert their pre-tax 401(k) deferral contribution accounts into after-tax Roth 401(k) accounts inside the qualified plan. Prior to this change, conversion could be accomplished only by rolling the 401(k) account out of the plan and into a Roth IRA.

Unfortunately, the law does not provide the tax planning opportunity for which so many had hoped — namely that participants would be permitted to convert their accounts at any time simply by retitling the account and paying the associated income tax. Why? Well, to begin, the “inside-the-plan” conversion option is available only to the extent the participant is eligible, under the terms of the plan, for immediate distribution of the funds. In some cases, an in-service distribution is available upon attainment of age 59 1/2, but many plans condition entitlement to distribution upon actual termination of employment. At that point, the participant very well might prefer to roll the account to an IRA over which he or she would have greater autonomy. In addition, of course, the plan document must provide both for the Roth 401(k) option and the conversion feature.

The new law is effective immediately. However, unless and until the plan is amended to permit conversion (or until the IRS sanctions some extended remedial amendment period within which the changes can be made with retroactive effect), it is unlikely a plan sponsor will (or should) permit transfer to a Roth account inside the plan. In fact, in an October 20 presentation to the American Society of Pension Professionals and Actuaries, the associate benefits tax counsel at the Treasury Department warned plan sponsors to wait for Treasury Department guidance before amending their plans or permitting in-plan conversions. Pointing out the law was “somewhat hastily crafted” and may not accurately reflect Congressional policy objectives, he explained that additional clarification will be needed.

Under pre-existing (though relatively recent) law, a participant may convert his or her 401(k) account by direct rollover to a Roth IRA. Moreover, the individual may revoke the conversion at any time prior to the (extended) due date of his or her tax return for the calendar year in which the conversion occurred. In fact, because of special tax treatment accorded to Roth IRA rollovers occurring in 2010 (which allows the taxpayer to pick up one-half of the taxable income in 2011 and the balance in 2012), the deadline for revocation may be much later. The Small Business Jobs Act of 2010 makes no mention of revocation of conversion inside the 401(k) plan. Barring additional guidance, then, we must assume conversion of a 401(k) account to a Roth 401(k) account within a qualified plan is irrevocable.

For more information regarding this topic, please contact Susan Foreman Jordan at 412.391.1334 or [email protected].