In 2010, Congress enacted new rules to allow plans to permit participants to “rollover” or transfer certain pre-tax amounts in their 401(k) plan to a designated Roth account within the plan. The amount transferred is taxable in the year of the transfer. Thereafter, if the Roth requirements are satisfied, the amount transferred and the earnings thereon may be withdrawn tax free.
In order to qualify as a transfer within the plan (in-plan Roth transfer or IRT) the amount to be transferred could not be subject to any restriction on its distribution from the plan. For example, pre-tax 401(k) deferrals cannot be distributed except if the participant is at least 59 ½ years old, terminates employment or certain other events. Thus, unless the participant satisfied the distribution requirements, he or she could not do an IRT. In 2013, as part of the budget deal, Congress expanded the scope of permitted IRT’s. The IRS has recently issued guidance clarifying the scope of these expanded rules.
The ability to convert pre-tax amounts into Roth amounts is an important tax-planning tool for participants. Participants who believe that they could be in a higher tax bracket when they retire (either because they believe their taxable income will grow, pushing them into a higher bracket, or because they believe that marginal tax rates will increase) could use this feature to convert some or all of their pre-tax amounts to Roth amounts.
The expanded rules also give plan sponsors flexibility in designing an in-plan Roth conversion feature. For one thing, sponsors can decide whether to allow participants to convert all pre-tax amounts to Roth amounts, or whether to allow conversions for only some types of pre-tax amounts. Plan sponsors will not have any withholding obligations with respect to converted amounts. Roth conversion features also are not considered protected benefits. In other words, a plan sponsor that adopts this feature could decide in the future to restrict its scope or eliminate it completely, so long as the change is applied on a non-discriminatory basis.
IRS Clarifications. The IRS guidance covers the following four substantive points:
First, IRS confirmed that the following contribution sources (including earnings) are allowed for IRTs: elective deferrals in 401(k) and 403(b) plans; employer matching and nonelective contributions; and annual deferrals made to governmental 457(b) plans.
Second, if the amount to be transferred may be distributed from the plan, the rules enacted in 2010 still apply. Thus, the required notice explaining the tax rules applicable to plan distributions must be supplied. However, this notice is not required for an IRT if the amount is otherwise not distributable.
Third, any amount rolled over as an IRT remains subject to the distribution restrictions that were applicable to the funds prior to the transfer.
Fourth, withholding does not apply to an IRT of an otherwise non-distributable amount, as the amount is not eligible for distribution, nor can a participant elect voluntary withholding.
Plan Amendments. IRS also provided plan sponsors a great deal of flexibility in amending their Plan to implement these new rules. Amendments to permit IRTs may be delayed to the last day of the first plan year in which the amendment is effective. So, for example, a calendar-year plan can implement the program now and delay the amendment until the end of 2014.
Safe Harbor plans may normally not adopt mid-year amendments, but a special rule allows them adopt an IRT program mid-year during 2014 only.
The extended amendment deadlines apply not only to a plan amendment allowing for an IRT of an otherwise non-distributable amount, but also the adoption of amendment permitting designated Roth accounts and IRTs generally.
Conclusion. The latest guidance is welcome and should facilitate the adoption of IRT programs. If you are interested in adopting such a program, contact your Plan Account Manager.
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