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.
Pre-Tax
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.
After-Tax
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.
Conclusion
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.
