October 27, 2010
New Roth Features for §401(k), §403(b) and Governmental §457(b) Plans
The Small Business Jobs Act of 2010 (SBJA),1 which was signed by President Obama on September 27, 2010, includes a number of provisions for §401(k), §403(b) and governmental §457(b) plans to consider with respect to Roth accounts. Very generally speaking, in an in-plan Roth conversion, a portion of the participant's pre-tax dollars is "converted" to after-tax dollars within the plan without the participant having to take an actual distribution and roll it over to a Roth individual retirement account (Roth IRA).2 This Compliance Alert summarizes the new Roth features that these plans may offer to their participants, including "in-plan" Roth conversions for §401(k) and §403(b) plans beginning this year and both Roth contributions and in-plan Roth conversions for governmental §457(b) plans beginning in 2011.
In-plan Roth conversions are complicated for both plans and participants. Plan sponsors might wish to delay a final decision about whether to adopt a conversion feature until they have been able to consider all of the issues (including whether and for what participant groups to allow in-service distributions),3 coordinate with the appropriate service providers, and review additional guidance, still to be issued, on the many unanswered questions. While the special tax rule that applies to Roth conversions in 2010, discussed below, appears to require quick action, those participants who wish to take advantage of the new benefit have been and still will be able to do so outside the plan, with most of the same tax benefits, through a rollover to a Roth IRA, if the plan allows them to take an in-service distribution.
Qualified Roth contribution programs were made available to §401(k) and §403(b) plans in 2006 under the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA).4 A qualified Roth-contribution program allows plan participants to make "designated Roth contributions" which are elective contributions of after-tax dollars in lieu of all or a portion of the pre-tax elective contributions permitted under the plan.
Designated Roth contributions are generally treated the same way as pre-tax elective deferrals; for example, they are 100 percent vested and they are subject to the same limits and the same distribution restrictions as pre-tax elective deferrals. However, when paid out in a "qualified distribution,"5 both the designated Roth contributions and the earnings on those contributions are distributed tax free. This tax-free treatment of earnings is the same as the treatment given to earnings on amounts properly distributed from Roth IRAs, but as described in more detail below, there are also some important differences between Roth accounts and Roth IRAs.
Governmental §457(b) Plans May Permit Roth Contributions
The SBJA permits governmental §457(b) plans to offer qualified Roth-contribution programs, including in-plan conversions, to their participants, effective for taxable years beginning after December 31, 2010. Governmental §457(b) plans generally must comply with the same rules for Roth contributions as §401(k) and §403(b) plans, described above.
§401(k) and §403(b) Plans Can Now Offer In-Plan Roth Conversions
Effective for §401(k) or §403(b) plan distributions after September 27, 2010, and for governmental §457(b) plan distributions in 2011, if the plan offers a qualified Roth contribution program, the plan can be amended to permit a participant to make an eligible rollover distribution within the plan from a non-Roth account to a designated Roth account. In this way, a participant who wishes to turn a portion of his or her pre-tax retirement savings into Roth contributions can convert otherwise distributable pre-tax amounts to after-tax amounts held in a Roth account inside the plan. Such a participant would no longer be required to take a distribution from the plan and roll it into a Roth IRA as would have been necessary before the SBJA changes. Of course, in either case, the participant must include the amount converted or rolled over in income for the year of conversion or rollover and pay taxes on it, subject to a special rule for 2010 discussed below.
There are a number of requirements that apply if a plan wishes to provide in-plan Roth conversions, including the following:
- The plan must offer a qualified Roth contribution program that allows participants to make designated Roth contributions. A plan cannot establish Roth accounts only to accept in-plan rollovers of pre-tax amounts for conversion.
- The plan must provide separate accounting and recordkeeping for each participant's designated Roth contributions and the related investment earnings.
- Because only pre-tax amounts that are eligible for distribution are eligible for in-plan conversion, the plan may permit additional types of in-service distributions, to the extent permitted by law, in order to allow participants to make in-plan conversions. The plan may condition eligibility for such new distribution options on the participant's election to make an in-plan conversion.
Issues for Consideration
There are many issues for plan sponsors to consider in deciding whether and when to offer in-plan Roth conversions. Some of these issues are as follows:
- Implementation in 2010 for §401(k) and §403(b) Plans Under a special tax rule that applies to Roth conversions in 2010, participants who make in-plan conversions this year will include the converted amount in taxable income over a two-year period, in 2011 and 2012, unless they decide to pay tax on the entire amount in 2010. Plan sponsors that wish to implement Roth conversions this year because of the special rule will have to act very quickly in order to accomplish what needs to be done in the time available. One of the very first action items to be considered is contacting critical partners such as payroll providers, administrators and recordkeepers to determine if they can accommodate the necessary changes in time.
- Unanswered Questions Further, just determining exactly what it is that will need to be done in 2010 will be a challenge. As with any new plan feature, there are many unanswered questions about how it will work. These questions include the details of reporting and withholding with respect to converted amounts and when plan amendments must be adopted. On this latter point, while the statute itself is silent, the legislative history states that Congress intended the IRS to provide a remedial amendment period for at least some of the changes a plan might want or need to make in order to implement the conversion feature, but no guidance has yet been issued.6
- Comparison to Roth IRAs As plan sponsors consider Roth conversions, they also might wish to consider how Roth accounts compare to Roth IRAs because that comparison might affect the decision whether, and if so, when to adopt the conversion feature. For example, in addition to amounts being tax free when properly distributed, another similarity between a Roth account and a Roth IRA is that the 2010 special tax rule, described above for conversion to Roth accounts, also applies to a rollover from a §401(k) or §403(b) plan to a Roth IRA or a conversion of a traditional IRA to a Roth account. Among the differences between Roth accounts and Roth IRAs is the difference in the ability to "revoke" a conversion. A conversion to a Roth account within a plan cannot be revoked. In contrast, an individual may revoke (or "recharacterize," as it is referred to in the IRC) the conversion to a Roth IRA until the due date plus extensions for individual tax returns for the year of conversion (regardless of whether or not the individual applied for the extension).7
Implications for Plan Sponsors
Governmental §457(b), §401(k) and §403(b) plan sponsors that are interested in adding a qualified Roth contribution program and/or offering conversion to Roth accounts within the plan should consult with their service providers. Implementation of these optional plan changes requires extensive analysis and a significant compliance effort. Participant communications will be especially important in this process because Roth conversion rules are complex and impact of a Roth conversion varies for each individual.
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As with all issues involving the interpretation or application of laws and regulations, plan sponsors should rely on their attorneys for authoritative advice on compliance with the Roth account provisions of the Small Business Jobs Act of 2010. The Segal Company can be retained to work with sponsors of governmental DC plans that are interested in adding a qualified Roth contribution program and/or offering conversion to Roth accounts within the plan.
- When the Act, which became Public Law No: 111-240, is available from the Government Printing Office (GPO), it will be accessible from the following Web page: http://frwebgate.access.gpo.gov/cgi-bin/browse?DB=111_cong_public_laws&template=plaws.tpl&sortoption=alphabetical (Return to the Compliance Alert.)
- Roth IRAs were introduced in 1997. In contrast to traditional IRAs, contribution to Roth IRAs are not deductible, but permit tax-free distributions (if certain requirements are met). The IRS Publication 590 provides details about Roth IRAs. (Return to the Compliance Alert.)
- An in-service distribution is a distribution that can be made to a participant while the participant is still employed, that is "in service." (Return to the Compliance Alert.)
- EGTRRA §617(a) added new Section 402A to the Internal Revenue Code (IRC) permitting "qualified Roth contribution programs" in §401(k) and §403(b) plans, effective in 2006. For more about Roth accounts in §401(k) and §403(b) plans, see the following page on the Internal Revenue Service (IRS) Web site: http://www.irs.gov/retirement/article/0,,id=156204,00.html (Return to the Compliance Alert.)
- Generally, a distribution is a qualified distribution if it is made at least five years after the participant's first designated Roth contribution and is made on or after the participant's age 59½, death or disability. (Return to the Compliance Alert.)
- See the Joint Committee on Taxation, Technical Explanation of the Tax Provisions in Senate Amendment 4594 to H.R. 5297, September 16, 2010, Page 43: http://www.jct.gov/publications.html?func=startdown&id=3707 (Return to the Compliance Alert.)
- For example, an individual who converts a traditional IRA to Roth IRA in 2010 will have until October 17, 2011 to revoke the 2010 conversion. (Return to the Compliance Alert.)
Compliance Alert, The Segal Company's periodic electronic newsletter summarizing important developments affecting benefit plan compliance, is for informational purposes only. It is not intended to provide authoritative guidance. On all issues involving the interpretation or application of laws and regulations, plan sponsors should rely on their attorneys for legal advice.