401(k) In-Plan Roth Conversions, Too Late for 2010?

On September 27, with passage of the Small Business Jobs Act, plan sponsors were permitted to allow some participants to convert their plan accumulations from tax-deferred to Roth status within their DC plans.

PSCA and other organizations worked for this change because of a concern that plan participants, particularly participants over 59 ½ with large account balances, would withdraw their plan assets and roll them over into an IRA to take advantage of Roth conversion rules effective in 2010. That change effective January 1, 2010, permits traditional IRAs to be converted to Roth IRAs without regard to the income limits that previously restricted such conversions. Further, there is a valuable tax benefit for conversions to Roth made in 2010. The amounts converted can be divided equally with one-half taxable in 2011 and the remainder taxable in 2012. For example, if someone converts $100,000 of tax-deferred savings to Roth in 2010 he or she would pay regular tax on $50,000 in 2011 and regular tax on the other $50,000 in 2012, spreading out the tax cost of the conversion.

The provision is not all that we hoped for, its complex and its late. We wanted legislation passed early in the year to permit participants to convert any funds held in a plan just by changing their tax related designation in the plan. Under the new law DC plan conversions are limited to amounts available for in-service distribution and not subject to the hardship distribution regime. Read literally, the law requires that assets first be distributed from the plan and then rolled back into the plan’s designated Roth account. Finally, the conversion is permitted only in plans that offer a designated Roth account for salary deferrals. A “pure” profit sharing plan without a 401(k) arrangement is not able to offer Roth conversions.

The provision created a concern that some employees would take advantage of the distribution provisions put in place to permit the Roth conversion by taking a cash out distribution of their plan accumulations, increasing leakage of retirement plan assets. A summary of the provision by the Joint Committee on Taxation (JCT) confirms that a distribution must be allowed under the plan to make the conversion. The JCT then adds several twists. It provides, “However, if an employer decides to expand its distribution options beyond those currently allowed under its plan, such as by adding in-service distributions or distributions prior to normal retirement age, in order to allow employees to make the rollover contributions permitted under this provision, the plan may condition eligibility for such a new distribution option on an employee’s election to have the distribution directly rolled over to the designated Roth program within that plan.” The JCT description also states that the rollover conversion can be achieved “operationally” by transferring funds to the designated Roth account without actually processing a rollover. Finally, the JCT notes that it “is intended” that the IRS will provide for a remedial amendment period to facilitate implementing any needed changes before the plan is formally amended.

Another provision in the legislation permits Roth accounts in governmental section 457 plans. Previously, only 401(k) and 403(b) plans were permitted to include this feature. This provision is effective for taxable years beginning after 12/31/10—too late to take advantage of the special features for 2010 conversions.

The ability to make 2010 conversions to Roth in DC plans faces significant operational and systems challenges compounded by the late starting date. If you want your participants to be able to take advantage of the special tax benefits for converting assets in 2010 with an in-plan Roth conversion you better get hopping.