IRS Issues Guidance on Roth 401(k) Conversions

Clarification for handling 2010 rollovers

By Stephen Miller Dec 1, 2010

Update: 'Fiscal Cliff' Law Eases Roth 401(k) Transfers

On Jan. 1, 2013, Congress passed the American Taxpayer Relief Act (H.R. 8), which was signed into law the following day. The legislation permits participants in pretax 401(k)s, 403(b)s and similar defined contribution retirement plans to elect to transfer amounts to a designated Roth 401(k) account, if available in their plan, at any time, with the transfer treated as a taxable qualified rollover contribution. While participants must pay income tax on funds transferred to the Roth 401(k) account, disbursements from the Roth account paid during their retirement years are made tax-free.

Employers must amend their plans to first allow for in-plan Roth 401(k) conversions.

Previously, converting funds from a pretax to a Roth 401(k) account was limited to money that was already "distributable" without penalty from the pretax plan—typically when an employee reached age 59½ or terminated employment, unless the plan otherwise allowed in-service distributions.

See "'Fiscal Cliff' Law Affects Payroll Tax Withholding and Employee Benefits."

In December 2010, the U.S. Internal Revenue Service issued IRS Notice 2010-84, containing guidance for 401(k) and 403(b) plans about in-plan Roth conversions. Under the guidance, U.S. employers can add a feature to their plans to allow participants to roll over and convert traditional 401(k) or 403(b) plan account balances that are distributable (available to be withdrawn or rolled over) under the plan into in-plan Roth accounts. In addition, the IRS posted additional information pertaining to the guidance, including a summary of key points and Form 1099-R and Form 8606 reporting instructions.

Under a provision in the Small Business Jobs and Credit Act signed into law in September 2010, a defined contribution retirement plan that includes a designated Roth program is permitted but not required to allow employees (and surviving spouses) to roll over vested account funds into the Roth option with no tax penalties, although income taxes must be paid on the converted funds. Subsequently, distributions of funds converted to a Roth account may be made tax free after five years (from the first day of the tax year in which the conversion was made) if the participant has reached age 59½, is disabled or has died (see the SHRM Online article "Roth Conversions within 401(k) Plans Now Permitted").

2010 Tax Deferral

But there is a special wrinkle for in-plan Roth conversions done in 2010, allowing participants to take advantage of a two-year special tax treatment window. For conversions completed in 2010 only, participants can opt to report nothing in 2010 and then recognize the income from the conversion in two equal parts on their 2011 and 2012 returns.

The IRS guidance clarifies that participants can do either of the following:

  • Report half of the taxable amount in 2011 and the other half in 2012 (two-year income spread).
  • Elect to report the entire taxable amount in 2010.
  • In order for a participant to be eligible for the 2-year income spread, the distribution to be rolled over in an in-plan Roth rollover has to be made no later than Dec. 31, 2010, and the plan must have a designated Roth account in place at the time the distribution is rolled over.

In addition, the notice states that:

  • Formal plan amendments may be made retroactively up to Dec. 31, 2011. A retroactive amendment can cover the needed addition of a Roth contribution option.
  • Conversions can be added to a safe harbor plan under an amendment adopted before Dec. 31, 2011.
  • A married participant who would normally need spousal consent to a distribution election does not need spousal consent to make an in-plan Roth direct rollover.

Clarification Had Been Sought

Due to uncertainty about the law, some had advised employers to wait until the IRS issued guidance before permitting in-plan Roth conversions (see "Industry Group Warns of Risks in Roth 401(k) Conversion").

However, "Thanks to guidance released by the IRS, employers and retirement professionals now have the necessary information to allow 2010 in-plan Roth conversions without permitting leakage of retirement savings," Brian H. Graff, executive director and CEO of The American Society of Pension Professionals & Actuaries (ASPPA), said in a statement.

According to Graff, prior to passage of the Small Business Jobs Act and the provision permitting participants to take advantage of Roth conversion rules within the plan, many plan sponsors were considering changes to permit workers to pull their retirement assets out of the plan so that these funds could be rolled over into a Roth individual retirement account (IRA). "ASPPA has voiced public concern about the potential for leakage out of retirement accounts for workers who had no intention of converting to a Roth account," Graff noted, adding that even if funds were converted from a traditional 401(k) to a Roth IRA, workers would be "forfeiting the protection and advantages of holding savings in an employer-sponsored retirement program."

Stephen Miller is an online editor/manager for SHRM.

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