|January 31, 2013|
The recently enacted American Taxpayer on Relief Act of 2012 (the “fiscal cliff” legislation) permanently expands the opportunity to make an “in-plan” conversion of retirement savings to Roth dollars. Under the expanded provisions, vested amounts, even if not otherwise distributable, may be transferred to a “Roth Rollover Account” within the plan. This allows participants to accelerate the payment of taxes to the year in which the rollover occurs in exchange for avoiding future taxes (including on future earnings) on distribution.
Previously, plans were only permitted to allow in-plan Roth conversions of vested amounts that were withdrawable. Thus, elective deferrals could only be rolled over to a Roth Rollover Account if the participant had attained age 59 ½ and the plan permitted in-service withdrawals. Now, a plan may permit any vested amounts (profit sharing, matching and after-tax contributions and elective deferrals including related earnings on each type of contribution) to be rolled over to a Roth Rollover Account. The plan may be a 401(k), 403(b) or 457(b) governmental plan as long as it permits Roth elective contributions.
EFFECT OF A CONVERSION TO A ROTH ROLLOVER ACCOUNT
The pre-tax amounts rolled over to a Roth Rollover Account are treated as if they were distributed and then rolled over to the plan as Roth contributions. They will be subject to Federal income tax in the year in which they were rolled over. Unlike the treatment of such rollovers in 2010, the Federal taxes may not be spread over two years. Based on prior guidance issued with respect to conversions prior to 2013, the 10% penalty tax on early distributions should not apply unless the rolled over amounts are distributed within the five-year period commencing on the first day of the calendar year in which the rollover occurred. Although there is no withholding on the converted amounts, a participant may need to pay estimated taxes (or increase his withholding on his regular compensation) to avoid paying penalty taxes.
Distributions from the Roth Rollover Account are treated in the same way as distributions of other Roth Contributions. Thus, a later distribution (including earnings earned after the rollover) is not subject to tax if it qualifies as a “Roth Qualified Distribution.” In order to be a Roth Qualified Distribution, a distribution from the Roth Rollover Account must be made after:
- at least five years from the January 1 of the year in which the rollover to the Roth Rollover Account occurred;.
Distributions from a Roth Rollover Account that are not Roth Qualified Distributions will be subject to tax to the extent allocable to earnings after the date of rollover, including the 10% penalty tax on early distributions (generally distributions before age 59 ½ unless another exception to the 10% premature distribution tax applies).
WHO IS LIKELY TO BENEFIT
The opportunity to convert retirement savings to a Roth Rollover Account will most likely appeal to (a) younger employees who are in a relatively low-tax bracket and (b) those who wish to have a combination of taxable and non-taxable retirement accounts. In addition, those with substantial after-tax accounts may want to convert those accounts, as upon conversion, taxes would only be due on the earnings on such contributions as the principal has already been taxed. It is best if the individual has sufficient funds outside of the retirement accounts to pay any taxes due to avoid depleting his or her retirement savings. Participants should be informed that, unlike Roth IRA conversions, in-plan Roth conversions are irrevocable.
These provisions are effective for conversions after 2012. Although no guidance has yet been issued, it is likely that this discretionary amendment must be adopted by the end of the first plan year in which it is effective (December 31, 2013 for a calendar-year plan if the amendment will be effective for 2013). As the extension of this opportunity is permanent, the amendments could be adopted for a later year when more guidance has been issued.