Before enactment of the Small Business Jobs Act of 2010 (SBJA), amounts held in section 401(k), 403(b) and 457(b) plans could be converted to a Roth-type retirement plan only by taking a distribution and rolling it into a Roth IRA. This put plan sponsors in a difficult position, because in-service distributions can be made only to the extent permitted under the plan document. If distribution options were expanded to increase the amounts that could be rolled over, participants might use distributions for purposes other than Roth conversions.
To solve this problem, the SBJA, signed into law in September 2010, included a provision (IRC § 402A(c)(4)) allowing in-plan conversions of amounts held in 401(k), 403(b) and 457(b) plans to Roth accounts and permitting plans to be amended to create a new distribution option solely for in-plan Roth conversions (IPRCs). Generally, an in-plan Roth conversion is available only to participants in eligible qualified plans who have separated from service, have died, are disabled, or are age 59½ or older. An additional category of eligible rollover is a “qualified reservist distribution.”
The SBJA did not address the nuts and bolts of the new option, however, leaving a number of questions unanswered. On Nov. 26, 2010, the IRS issued Notice 2010-84 (tinyurl.com/6lbqlye) providing detailed IPRC guidance in a question-and-answer (Q&A) format. This article summarizes the guidance, discusses tax treatment of the conversion, and describes why, for most taxpayers, a conversion to a Roth IRA is likely to remain a more favorable option than an IPRC.
NOTICE 2010-84 GUIDANCE
Effective Sept. 28, 2010, section 401(k) and 403(b) plans may permit qualifying participants to convert their accounts to Roth accounts in the same plan. Effective Jan. 1, 2011, section 457(b) plans (government plans) have the same option. The conversion can be accomplished either by a direct rollover to the Roth account or by a distribution of funds to the individual, who then rolls over the funds into his or her designated Roth account in the plan within 60 days.
Persons eligible to make an IPRC. A rollover election can be made not only by a plan participant but also by a surviving spouse beneficiary or by an alternate payee who is a spouse or former spouse (Notice 2010-84, Q&A 14).
Amounts eligible for conversion. Amounts can be eligible for conversion only if they meet both Code and plan requirements, specifically, (1) the amount is vested; (2) the plan has a qualified Roth contribution program in place at the time an IPRC is made to the Roth account (not accounts created solely for the purpose of receiving rollover amounts); (3) the conversion meets the requirements for a distribution under the Code and is an eligible rollover distribution under section 402(c)(4); and (4) the plan’s governing instrument permits distributions for rollover purposes (see Q&A’s 2 and 19).
A plan can be amended to add an IPRC option for amounts that are permitted to be distributed under the Code but could not be distributed under the plan’s more restrictive terms. As noted above, the amendment does not need to permit any other rollover or distribution option for these amounts that would cause “leakage” of plan assets (Q&A 4).
Besides the restrictions on eligible participants’ age and status noted above, amounts that would not qualify for a rollover to another eligible retirement plan do not qualify for an IPRC. These include required minimum distributions (RMDs), hardship distributions, corrective distributions of excess deferrals, dividends from employer securities and deemed distributions (Q&A 2).
IPRC treated as a plan distribution for limited purposes. Treating the IPRC as a distribution for all purposes of the Code would produce unwanted tax consequences. Thus, Notice 2010-84 makes it clear that an IPRC is treated as a distribution only for the limited purpose of treating amounts as includable in a Roth account. This means that (1) a plan loan transferred as part of the IPRC without changing the repayment schedule is not treated as a new loan; (2) a plan participant does not need spousal consent to do an IPRC; (3) the converted amount continues to be counted for purposes of determining whether the $5,000 involuntary cash-out rule applies; and (4) any distribution right the participant had prior to the rollover continues to apply.
The taxable amount for an IPRC is the same amount that would be included in gross income if the rollover were made to a Roth IRA. This amount is the fair market value of the distribution, including net unrealized appreciation minus any basis the taxpayer has in the distribution from after-tax contributions (Notice 2009-75).
This taxable amount is included in income for the year of the conversion, except optionally for conversions in tax years beginning in 2010, when a taxpayer could choose between including the full taxable amount in income in 2010 or making half the amount taxable in 2011 and half in 2012. If the taxpayer elected to recognize all the income in 2010, the election cannot be changed after the due date (with extensions) for filing the taxpayer’s 2010 income tax return. To be eligible for the two-year deferral period, the IPRC distribution must have been made no later than Dec. 31, 2010 (Q&A 19).
Special income acceleration rules apply to taxpayers who did IPRCs in 2010, deferring income recognition, and then take distributions in 2010 or 2011 that are allocable to the 2010 rollover. For such taxpayers, the accelerated income first reduces the amount included in income in 2012. If the accelerated income exceeds the 2012 taxable amount, any excess is used to reduce income reported in 2011.
Example. A plan participant made an IPRC in 2010. The taxable amount is $8,000, so $4,000 was initially deferred until 2012 and $4,000 to 2011. The participant then takes a distribution in 2010 or 2011 of $5,000 that is allocable to the taxable amount of the 2010 IPRC. If the distribution occurred in 2010, the participant’s gross income for 2010 is increased by $5,000; his or her gross income for 2012 is reduced by $4,000; and gross income for 2011 is reduced by $1,000 (Q&A 11). If the distribution occurred in 2011, the $4,000 of 2012 income allocable to the 2010 IPRC would presumably be accelerated to 2011.
The income acceleration rule does not apply if the participant takes a distribution that is rolled over into another designated Roth account or to a Roth IRA. It does apply, however, to subsequent distributions from the transferee Roth account or Roth IRA.
Mandatory withholding. The section 3405(c) 20% mandatory withholding requirement does not apply to an IPRC. Because the conversion is taxable, however, it will increase taxpayers’ income for the year and might make it necessary to increase their withholding or make estimated tax payments to avoid an underpayment penalty.
Tax on early distributions. IPRCs are generally not subject to the section 72(t) 10% additional tax on early distributions. Under a special rule, however, if an amount allocable to an IPRC is distributed within five years after the first day of the participant’s taxable year in which the rollover was made, the amount distributed is treated as includible in gross income for the purpose of applying section 72(t) to the distribution.
For example, if a participant withdrew $6,000 allocable to an IPRC during the five-year period, the participant would be subject to $600 of additional tax unless an exception to section 72(t) applied. The five-year recapture rule does not apply to a distribution that is rolled over to another designated Roth account or to a Roth IRA owned by the participant, but it does apply to a subsequent distribution from the transferee account within the five-year period (Q&A 12). Q&A 13 provides a comprehensive example of how allocations are made to the taxable amount of an IPRC for purposes of the income acceleration and five-year recapture rules.
IPRC VS. ROLLOVER TO A ROTH IRA
Taxpayers wishing to convert assets in 401(k), 403(b) or 457(b) plan to a Rothtype retirement vehicle will now have two choices. They can roll amounts into a Roth IRA or roll them into a Roth account inside the plan. Which is the better option? The answer may depend on the taxpayer’s circumstances. The key variables in making the decision are (1) asset protection, (2) estate planning considerations and (3) the ability to recharacterize the conversion.
Asset protection. An ERISA plan, such as a 401(k), 403(b) or 457(b) plan, offers substantially more protection from creditors than a Roth IRA. This is an important factor favoring IPRCs for taxpayers in high-risk professions such as medicine, law and accounting.
Estate planning. Taxpayers must take RMDs from designated Roth contributions within a 401(k), 403(b) or 457(b) plan but not from a Roth IRA (see Treas. Reg. § 1.401(k)-1(f)(4)(i)). This makes a Roth IRA much more favorable for accumulating wealth to pass on to heirs for taxpayers who do not need to rely on the assets to provide income during their retirement years.
Recharacterizations. A conversion to a Roth IRA can be recharacterized back to a qualified plan if the underlying assets perform poorly after the rollover, but an IPRC cannot. This can be a very important advantage for a Roth IRA conversion, particularly if the plan to be converted holds volatile assets. Suppose, for example, that a taxpayer has $500,000 in a 401(k) plan and makes an IPRC. The value of the assets subsequently falls to $350,000. The taxpayer has paid tax at ordinary income rates on $150,000 of value that he or she no longer owns. By contrast, if the conversion had been to a Roth IRA, the taxpayer would have until the following Oct. 15 to reverse the transfer.
Bottom line: Converting outside the plan may be better. The foregoing suggests that most taxpayers would be better off making a Roth conversion outside the plan than an IPRC. For the typical taxpayer with little exposure to creditors, the ability to recharacterize will outweigh the asset protection disadvantage even when there is no estate planning benefit. Only taxpayers in high-risk professions might be better off with an IPRC. Even for these taxpayers, it may be best to keep assets in an IPRC only temporarily. High-risk professionals might convert to a Roth-designated account shortly after they reach age 59½ to provide protection during the last years of practice and the first few years of retirement, when they might continue to be exposed to malpractice claims. Then, when they reach age 70, the Roth account could be converted to a Roth IRA. This strategy would not limit the estate planning benefits of a Roth IRA, because no RMDs would be required while the assets were in the Roth account. The taxpayer would lose the ability to recharacterize with the IPRC, but the risk that the retirement assets would later drop in value could be minimized by funding with assets having relatively low volatility.
OTHER ADMINISTRATIVE CONCERNS
Notice requirement. A plan that permits IPRCs must include a description of this feature in the written explanation the plan provides to an individual receiving an eligible rollover distribution. If the plan uses the safe harbor explanation provided in Notice 2009-68, this description of the IPRC option could be added as a new section titled “Special Rules and Options.” That section would briefly explain the IPRC rules discussed above (Q&A 5).
Plan amendments. Discretionary plan amendments, such as adding an IPRC feature, would ordinarily have to be adopted by the last day of the plan year in which the amendment is to be effective. To facilitate rollovers before the end of 2010, Notice 2010-84 extended the deadline for amending a non-safe-harbor 401(k) plan to permit IPRCs to the later of the last day of the plan year in which the amendment is effective or Dec. 31, 2011, provided that the amendment is effective as of the date the plan first operates in accordance with the amendment (Q&A 15). A safe-harbor 401(k) plan generally must be amended by the later of the first day of the plan year in which the amendment is effective or Dec. 31, 2011 (Q&A 18). The deadline for amending a section 403(b) plan to add an IPRC feature is generally the end of the remedial amendment period for bringing the plan into compliance with the section 403(b) regulations (Q&A 16).
Eligible participants in certain qualified retirement plans that permit the option now may make an in-plan Roth conversion (IPRC) of amounts under IRC § 402A(c)(4), enacted last year by the Small Business Jobs Act. Generally, participants who have separated from service, have died, are disabled, or are at least age 59½ are eligible. Beginning Sept. 28, 2010, an IPRC could be offered by section 401(k) and 403(b) plans; beginning Jan. 1, 2011, they were joined by section 457(b) plans.
Guidance on making an IPRC is given in IRS Notice 2010-84, including such details as other beneficiaries or alternate payees who may make the rollover election, vesting and other requirements for amounts eligible for conversion and implications for plan loans, consents and other procedural considerations.
The guidance also addresses the tax deferral and spreading of income recognition to 2011 and 2012 of IPRCs made in 2010 and income acceleration provisions that come into play for distributions made during the recognition period allocable to such conversions.
A rollover from a qualified plan to a Roth IRA may still be preferable to an IPRC for many or most taxpayers. Generally, leaving assets in-plan may be indicated for account owners in occupations with high liability risks, since left there, assets have greater protection from creditors than in a Roth IRA. However, for other taxpayers, an IPRC poses potential disadvantages of required minimum distributions (RMDs) and that it may not be “unwound,” or recharacterized. A Roth IRA, on the other hand, does not have RMDs, and a conversion to it may be recharacterized within a limited period.
Peter J. Melcher, Esq.(email@example.com), is a consultant with Keebler & Associates LLP in Green Bay, Wis.
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