The American Taxpayer Relief Act (ATRA) expanded the opportunity for participants to convert existing tax-deferred money in 401(k), 403(b) and 457(b) plans to Roth accounts in the same plan. This applies to transfers made after Dec. 31, 2012.
What the IRS allows
Prior to the new law, the in-plan Roth rollover conversion feature allowed participants to make in-plan rollovers for distributable amounts, such as separation from service (termination), in-service distributions, death or disability. The new law permits an in-plan Roth conversion without having a distributable event. The law also permits rollover amounts from pretax, matching or after-tax accounts to a Roth account within the same plan.
Even though the IRS treats the rollover as a taxable distribution from a tax-deferred account, by paying tax in the conversion year, participants can potentially save future taxes on the principal amount. And future investment gains are distributed income–tax-free. Bear in mind that these types of conversions don’t allow participants to change their mind after the conversions are made. Recharacterizations aren’t allowed.
ATRA also reduced individual tax consequences, such as a 10% early distribution penalty, by changing the requirement that they have a distributable event (such as reaching age 59½) to make an in-plan Roth rollover. Thus, plan sponsors no longer will have to ascertain if the participant is eligible for an in-service distribution under their plan’s terms before a rollover.
What plans need to do
When offering in-plan Roth rollovers, the plan must allow Roth contributions; it can’t permit the conversion unless it already allows them. Employers don’t have to offer this option, but if they elect to do so they must make a plan amendment by the end of the plan year in which the amendment is effective.
As under prior law, plans must make eligibility for the in-plan Roth rollovers available to surviving spouse beneficiaries and alternate payees who are current or former spouses. As of this writing, the IRS hasn’t published final guidance for plan amendments. Most document providers will wait to draft model amendments until the IRS publishes its guidance. Remember, even with the guidance, any amendment must take place by the end of the plan year in which it’s effective.
Roth distribution considerations
While ATRA focused on rollovers from existing tax-deferred money in 401(k), 403(b) and 457(b) plans to Roth accounts in the same plan, don’t forget to communicate Roth tax consequences to participants. A Roth distribution is tax-exempt if it satisfies certain requirements.
For example, the Roth distribution must be held for five years and be made after an individual reaches age 59½, is disabled or dies. If any portion of the taxable amount is distributed within a five-year period (which begins on the first day of the tax year in which the rollover was made), it’s subject to the 10% additional penalty on early distributions unless the participant is age 59½ or older.
Get ready to offer rollovers
Employers drafting the in-plan Roth rollover should work with their employee benefits advisors to coordinate account administration with participant communications, recordkeeping and nondiscrimination testing. Also, be prepared to clearly discuss the new Roth rollover option to participants.