Saturday, December 20, 2014

Plan Design: In-Plan Roth Conversion

Nicholas Zaiko, CIMA®
Investment Consultant
Bridgebay Financial, Inc.

The In-Plan Roth Conversion provision is a plan feature introduced by the American Taxpayer Relief Act (ATRA) in January, 2013 that permits participants to convert pre-tax balances that are vested to after-tax Roth balances within the plan.  Expanding in-plan Roth contributions may prove to be a powerful tool for plan participants and a welcome enhancement to plan sponsors' retirement offerings.

IRS Notice 2013-74 dramatically increases participants' ability to convert pre-tax savings into after-tax Roth retirement savings by expanding the pool of eligible assets. 

Traditional DC plans such as 401(k), 403(b) and government 457(b) plans allow participants to make pre-tax deferrals to their plan.  These contributions reduce their current tax liability but ultimately, the withdrawals taken during retirement are taxed at regular income tax rates. 

With Roth versions of 401(k), 403(b) and 457(b) plans, participants contribute after-tax amounts that will be taxed in the year of their contribution, however,  withdrawals  will be tax-free.  In-Plan Roth rollovers enable participants to convert pre-tax retirement amounts into an after-tax account (Roth), paying taxes in the year of the conversion.

New IRS Guidance
On December 11, 2013 the IRS issued Notice 2013-74 which expands  the previously limited in-plan Roth conversion option to all vested amounts under eligible plans.  The new rule also allows amounts that are not yet eligible for distribution.

Plan sponsors are not required to offer in-plan Roth conversions to their participants.  Plan sponsors may limit the types of vested pre-tax contributions  to be converted (employer/employee), may  designate the frequency of elective conversions and may choose to discontinue the conversion program, as long as it is done in an equitable manner.

In-Plan Roth Conversion Process
A participant can make an in-plan Roth conversion by transferring assets from a non-Roth account into a designated Roth account within their retirement plan.   The amount transferred from pre-tax to after-tax becomes taxable in the year of the conversion. 

The participant is paying taxes up-front on its converted balances so that in the qualified distributions taken by the participant during retirement may not be taxed.   Essentially, the participant is paying taxes today to avoid paying taxes in the future.  According to the tax law, both the cumulative contributions and any accumulated earnings are both tax-free when withdrawn by the participant in a qualified distribution.  In order to qualify for tax-free status, among other criteria, the assets must be held in the Roth account for at least five years prior to distribution.

Eligible Pre-Tax Amounts
Prior to the new regulations, the only amounts in a pre-tax retirement plan that were eligible for Roth conversion were amounts that were otherwise distributable under tax law.  The new expansion of eligible amounts now covers all vested assets within a pre-tax plan including those that were previously excluded from conversion.

The Notice clarifies that plan sponsors may decide and restrict the types of vested contributions eligible for conversion within their own plan.  The frequency of conversions is also left to the discretion of the plan sponsor.  The plan sponsor must ensure, however, that any restrictions that are implemented do not  disproportionately favor highly compensated employee.

Tax Considerations
The guidance specifically identifies in-plan Roth conversion amounts as not being subject to income tax withholding.  This means that when a participant converts a pre-tax amount to an after-tax Roth amount, the income tax withholding for the year will be insufficient to cover their annual tax liability.  The conversion will trigger an increase in tax liability and the Notice warns that employees who choose to partake in the in-plan Roth conversion either increase their withholding rates or make estimated tax payments to cover the additional income tax liability

Administrative Considerations
Despite characterizing Roth conversions as in-plan "rollovers" from non-Roth to Roth accounts, the new law does not require plan administrators to provide Code section 402(f) notices regarding the tax implications of rollover distributions to participants who choose the make in-plan Roth conversions of non-distributable amounts.

Distribution Restrictions
Any amounts with specific distribution restrictions that are selected for conversion from pre-tax to after-tax Roth amounts will retain those same restrictions after the completion of the conversion.  The IRS suggests that for the simplicity of recordkeeping purposes, plan sponsors simply exclude those amounts with distribution restrictions from the amounts eligible for conversion.  Again, the Notice leaves the determination of eligible assets entirely up to the plan sponsor.  This would eliminate the need to track different converted amounts with different distribution restrictions, dramatically simplifying recordkeeping.

Qualified Roth Distributions
Several requirements must be met for Roth distributions to be considered qualified and therefore tax-free.  Primary among these criteria is the five-year period for qualification.  A qualified distribution must come from a Roth account made more than five taxable years after the first year the participant contributed to the Roth account.  In order to calculate the five-year period, the IRS has stated that if an in-plan Roth conversion is a participant’s first contribution to a Roth account in the plan, the five-taxable-year period begins on the first day of the taxable year in which the in-plan Roth conversion was made.

Converted Excess Contributions and Deferrals
In some cases, contributions and deferrals may later be determined to be in excess of limits.  Excess contributions may occur under the Internal Revenue Code (IRC) nondiscrimination rules.  Excess deferrals may occur under the IRC individual deferral limit.  If any converted amounts are  determined to be in excess, those amounts must be distributed from the Roth account.  This includes amounts that were previously designated non-distributable at the time of the in-plan Roth conversion.

Amending the Plan Document
In order to offer in-plan Roth conversions plan sponsors must amend their plan document before the end of the first calendar year in which they choose to add the feature.  For safe harbor plans with mid-calendar year-ends, the IRS allows for such plans to implement in-plan Roth conversions immediately. 

The Internal Revenue Service (IRS) recently issued guidance on the new legislation that could significantly expand the use of in-plan Roth rollovers in defined contribution (DC) plans.  Plan sponsors have the opportunity to offer expanded in-plan Roth conversions and should seriously evaluate the feature in light of their plan demographics, income levels and tax brackets before deciding to add this feature.