Opportunity for In-Plan Roth Conversion Expanded

May 2013Articles For Your Benefit
Included in the Small Business Jobs and Credit Act of 2010 was a provision which enabled participants in 401(k) plans to convert their pre-tax salary deferral contribution accounts into after-tax Roth accounts through in-plan Roth rollover. Until that option was added, Roth conversion could be accomplished only through direct rollover from the plan to a Roth IRA. At that time, however, in-plan Roth rollover was available only to participants who then were eligible for distribution from the plan. Consequently, unless and until the participant had attained age 59-1/2 and unless the plan permitted in service distributions, in-plan Roth rollover was not an option.

Under the American Taxpayer Relief Act of 2012, the availability of in-plan Roth conversion is extended, on a permanent basis, effective January 1, 2013, to all participants with pre-tax salary deferral contribution accounts, whether or not otherwise is eligible for distribution. Although the original 2010 legislation allowed taxpayers to split the income tax liability over two years, under current law, the full amount will be included in income the year in which the account is converted, in the same manner as if that amount had been distributed directly to the participant.

Generally speaking, the 10% early distribution excise tax does not apply to an in-plan Roth conversion, regardless of the participant’s age. However, there is a recapture rule while will result in imposition of that added tax, if the participant takes a distribution from the Roth account (to which the early distribution penalty would apply) within five years. Certainly, the benefits of Roth conversion must be weighed against the cost, given the recently increased income tax rates, and in light of the fact that in-plan conversion (unlike Roth IRA rollover) is irrevocable. However, Roth conversion may remain appealing to those individuals who expect that their income tax rates will increase further in the future. Likewise, because the minimum distribution requirements do not apply to Roth accounts, wealthy individuals who desire to preserve and pass on to their heirs more of their retirement savings may want to take advantage of this new opportunity.

Keep in mind that in-plan Roth conversion is not permissible unless the plan expresslyprovides for that option. A number of issues remain unresolved, including whether distribution restrictions continue to apply to converted amounts, whether plans may impose an all-or-nothing requirement with regard to conversion, what plan language is required, and what impact the conversion option will have on various disclosure materials. As such plan sponsors are advised to delay action to add or implement the expanded in-plan conversion provisions, pending the issuance of further guidance by the IRS.