In-Plan Roth Conversions Under the Small Business Jobs Act
On September 27, 2010 President Obama signed into law the Small Business Jobs Act of 2010 (the “Act”). The Act includes two retirement plan provisions that raise revenue, to help pay for the tax breaks to small businesses provided for under the law:
- The first provides a special conversion opportunity that a plan sponsor may (but is not required to) offer to plan participants under its 401(k) or 403(b) plan.
- The second allows governmental 457(b) plans to offer a Roth feature and the Roth conversion feature beginning in 2011.
A Roth contribution provision under a 401(k) or 403(b) plan allows a plan participant to make contributions to a plan on an after-tax basis to a separate designated Roth account subject to the annual deferral limits ($16,500 for 2010) under Treasury regulations. The deferral limit is a single annual limit for each participant, meaning a participant may annually make deferral contributions that are all after-tax, all pre-tax, or some combination of the two. Provided the participant meets the requirements for Roth accounts, all distributions will be tax-free when paid upon a qualifying event.
Under existing law effective for 2010, participants eligible to receive a distribution from their employer’s plan can elect to roll over their qualified plan distribution to a Roth IRA. The rollover amount is taxable income; however, for 2010 the law allows a plan participant to pay the income tax on the conversion to a Roth IRA in two equal installments in 2011 and 2012.
Observation: Under these rules, plan participants eligible to receive a distribution were forced to remove their assets from the employer’s (or former employer’s) plan. Under the provisions of the Act, this will no longer be necessary as long as the plan sponsor adds this feature to its plan.
The New Law
Under the Act an employee can elect to convert some or all of certain amounts that were contributed to a plan on a pre-tax basis into a Roth after-tax account inside of the plan, which is known as an “in-plan” Roth conversion. The Act allows 401(k) plans and 403(b) plans to provide such a provision effective after September 27, 2010. However, the plan document must be amended to provide for the in-plan conversions and such an amendment cannot be limited to in-plan conversions, meaning that such an amendment must also incorporate a Roth feature to allow plan participants to make Roth contributions.
Observation: If a plan sponsor wants to provide for this option in 2010 so that plan participants can take advantage of the ability to pay the resulting income tax over two years, the plan document must be amended by December 31, 2010 unless the Internal Revenue Service provides for additional time. Further, the in-plan conversion must be completed by December 31, 2010 to take advantage of the special tax election.
Application to Plans and Participants
Any current or former plan participant (with an account balance in the plan) who is permitted to receive an eligible rollover distribution (ERD) can make the Roth conversion election. The election is available to surviving spouses, but not non-spouse beneficiaries. There is no income limit or filing status restriction for this election. The conversion may be applied to any type of vested contributions (and earnings thereon) that are currently distributable (see discussion below) and would be treated as an ERD. Contribution types eligible for conversion include pre-tax 401(k) and 403(b) deferrals (beginning in 2011, governmental 457(b) deferrals), matching contributions, profit sharing contributions, and after-tax contributions.
Eligible Rollover Distributions
The amount to be converted must otherwise qualify as an ERD, which excludes the following:
- A required minimum distribution.
- Any of a series of substantially equal payments made at least once a year over any of the following periods:
- The employee's life or life expectancy.
- The joint lives or life expectancies of the employee and beneficiary.
- A period of 10 years or longer.
- A hardship distribution.
- The portion of a distribution that represents the return of an employee's nondeductible contributions to the plan.
- Loans treated as distributions.
- Dividends on employer securities.
- The cost of any life insurance coverage provided under a qualified retirement plan.
Further, in order for active participants (those actively employed by the plan sponsor) — other than participants who have reached normal retirement age — under a plan to take advantage of the Roth conversion provision, the plan document must provide for in-service distributions. Such participants would not otherwise be eligible to receive an ERD. A plan may generally allow the following types of in-service distributions to active participants:
- After-tax contributions and rollover amounts that are held in a separate account can be distributed at any time;
- Pre-tax deferrals can be distributed upon reaching age 59-1/2; and
- Employer contributions can be distributed if they are vested and have been in the plan for at least two years or the participant has participated in the plan for at least five years.
Observation: Plan sponsors need to consider the consequences of making such changes to their plans — specifically that such in-service distributions will allow participants to take distributions from the plan for any reason if they meet the above requirements.
Next Steps for Plan SponsorsPlan sponsors will have little time to weigh the pros and cons as well as well the costs of the administration and communication steps needed to properly implement the in-plan Roth provision to their plans. If they are not currently permitting in-service distributions, there may be valid reasons for not adding such provisions to the plan. If only a limited number of participants might use the in-plan Roth conversion, plan sponsors may simply continue to provide the right to transfer to a Roth IRA, which plans must offer beginning in 2010, since there is no requirement for plan sponsors to offer an in-plan Roth conversion feature.
For further information on any of these provisions, please contact Peter Alwardt or another EisnerAmper LLP professional.