Using a Qualified Plan Account to Fund a Roth IRA Conversion

Roth IRAs have become popular retirement savings options since their introduction in 1998. However, high-income individuals have not been able to take advantage of the Roth IRA opportunity. Recent tax law changes expand the Roth IRA to all taxpayers who have or could have traditional IRA accounts.

Background

Before 2010, the Internal Revenue Code limited the opportunity to convert a traditional individual retirement account (IRA) into a Roth IRA to individuals with adjusted gross income of less than $100,000 (not indexed). In addition, the Code prevented all individuals with a married filing separately tax filing status from electing a Roth IRA conversion, regardless of their income levels. In 2006, Congress enacted the Tax Increase Prevention and Reconciliation Act (TIPRA, PL 109-222), which prospectively repealed (effective Jan. 1, 2010) both the $100,000 income limit for conversions and the restrictions applicable to taxpayers who are married filing separately. Therefore, as of Jan. 1, 2010, all taxpayers are eligible to convert a regular IRA to a Roth IRA regardless of their filing status or income level.

The Roth Advantage

Unlike traditional IRA accounts, qualified distributions of the earnings in a Roth IRA account are free from federal income tax (see IRC § 408A(d)). In addition, Roth IRA accounts are, during the IRA owner’s lifetime, not subject to the required minimum distribution rules of section 401(a)(9)(A) (see section 408A(c)(5)). A spousal beneficiary of a Roth IRA can continue to defer the distribution of the account (see section 401(a)(9)(B)(iv)). Nonspousal beneficiaries of a Roth IRA will have to begin distributions after the participant’s death (see section 408A(c)(5)). The price a taxpayer pays for the tax-free distribution and the extended period of tax-free buildup of assets is that the taxpayer must fund current-year Roth IRA contributions with after-tax money and must pay tax on Roth IRA conversion transactions.

Types of Retirement Accounts Eligible for Conversion

A taxpayer may elect a Roth IRA conversion of a traditional IRA or may convert an eligible rollover distribution as defined under IRC § 402(c)(8). Plans eligible for rollover include qualified plans such as pension, profit sharing, or 401(k) plans; 403(b) annuity plans; and governmental section 457 plans. A taxpayer may also convert a SEP IRA or SIMPLE IRA. However, a SIMPLE IRA is not eligible for conversion until the applicable two-year period under section 72(t)(6) expires: A 25% premature distribution penalty applies to any distributions made before the SIMPLE IRA participant has either completed two years of participation or reached age 59½ (see Treas. Reg. § 1.408A-4, Q&A-4).

The Problem

TIPRA’s expansion of the conversion opportunity is a welcome change. However, many high-income individuals do not have IRA accounts to convert because of restrictions on the deductibility of IRA contributions by taxpayers who are active participants in a retirement plan (IRC § 219(g)). This deductible contribution restriction was part of the Tax Reform Act of 1986 (PL 99-514). Thus, substantial numbers of taxpayers may currently be high earners but have either no or a relatively small IRA account balance to convert.

A Solution

One solution is to take advantage of the in-service distribution rules applicable to certain tax qualified plans. This can be a particularly effective strategy for individuals who have a certain degree of influence as to the terms of their qualified plans. For example, employees of small business and professional firms often have the ability to influence the provisions of the plan document; to the extent that a plan does not provide for in-service distributions, the employer may be able to amend the plan to provide that feature.

Rules Regarding In-Service Distributions

Defined benefit, cash balance, and money purchase pension plans generally cannot permit in-service distributions before age 62. Similarly, a 401(k) plan cannot permit in-service distributions of employee elective deferral accounts prior to age 59½. However, the rules applicable to employer profit sharing and employer matching contributions are substantially more liberal (even if the accounts are part of a 401(k) plan). Employer profit sharing and matching contributions are available for an in-service distribution upon any of the following events: The money has been in the plan for a fixed number of years (at least two years); the employee has participated in the plan for five years; or the employee has attained an age set forth in the plan document (see Treas. Reg. § 1.401-1(b) (1)(ii) and Revenue Rulings 71-295 and 68-24).

Rollover contributions and voluntary after-tax contributions are not employer-provided benefits, and the restrictions on in-service distributions are not applicable to those types of accounts. Thus, a plan can distribute both rollover and after-tax voluntary contribution money at any time (see Revenue Ruling 2004-12).

Considering the popularity of safe harbor 401(k) plans, in-service distributions of qualified nonelective contributions and qualified matching contributions (including safe harbor match and safe harbor nonelective contributions) are not permissible before the employee reaches age 59½ unless the employee dies, becomes disabled, has a severance from employment, or has a hardship, or there is a termination of the plan (Treas. Reg. § 1.401(k)-1(d)(1)). Uniquely, the in-service distribution rules applicable to 403(b) plans depend on the applicable funding vehicle. The rules for annuity-funded plans are more liberal than for plans that use custodial accounts invested in regulated investment company stock (mutual funds). In either case, amounts attributable to 403(b) elective deferrals are not available for in-service distributions before age 59½ unless the employee has a severance from employment, dies, has a hardship, or becomes disabled, or the distribution is a qualified reservist distribution (see IRC §§ 403(b)(7)(A)(ii) and 403(b)(11)).

For employer contributions invested in a custodial account, the same rules apply (see section 403(b)(7)(A)(ii)). However, for employer contribution amounts held in an annuity contract, the plan may provide for in-service distribution upon the occurrence of any specified event (for example, fixed number of years, attainment of specified age, disability) (see section 403(b)(11) and Treas. Reg. § 1.403(b)-6(b)). Accounts held in a retirement income account (church plans only) follow the same rules as an annuity-funded plan (see section 403(b)(9)).

With respect to section 457(b) plans, there are substantial restrictions on distributions. A 457(b) plan may not make amounts deferred under an eligible plan available to a participant or beneficiary earlier than: (1) the calendar year in which the participant attains age 70½; (2) when the participant has a severance of employment from the employer; or (3) when the participant faces an unforeseeable emergency (see section 457(d)(1)(A)).

Mechanics of the Conversion

A taxpayer may roll over all or part of a distribution from an eligible retirement plan to a Roth IRA (a conversion transaction) either by a direct rollover to the Roth IRA or by rolling over the amount received within 60 days. The rollovers can take place if the employee has terminated employment or has, as discussed above, had a distributable event. The disadvantage of a 60-day rollover is that the distributing plan must withhold 20% of the eligible rollover distribution for federal income tax purposes (see IRC § 3405(c)).

Taxation of a 2010 Conversion

For conversions occurring in 2010, unless the taxpayer elects otherwise, the taxpayer recognizes the amount required to be included in gross income over two years, half in 2011 and half in 2012 (see IRC § 408A(d)(3)(A)). The income recognition is deferred and may serve to reduce the marginal tax rate and total taxes due on what otherwise would be a larger single-year distribution. The 10% early withdrawal penalty does not apply to the conversion amount (see section 408A(d)(3)(A)(ii)). However, if a taxpayer withdraws any of the converted funds from the Roth IRA before reaching age 59½, the 10% premature distribution penalty will apply for the taxable portion of the distribution (unless another exception to the premature distribution penalty applies).

The Recharacterization and Reconversion Safety Valves

It is possible to reverse a Roth IRA conversion. A taxpayer may recharacterize the conversion (in essence, undo the transaction) by transferring the amount contributed to the Roth IRA to a traditional IRA by the due date (including extensions) for filing the taxpayer’s federal income tax return. The transfer must include earnings (net gain or net loss) attributable to the contribution (see Treas. Reg. § 1.408A-5). It is also permissible after completing a recharacterization transaction to reconvert the recharacterized amount in a second Roth IRA conversion. However, the taxpayer must wait until the later of:

• The first day of the tax year following the tax year in which the taxpayer converted to a Roth IRA; or
• Thirty days after the taxpayer completes the recharacterization transaction.

This three-step conversion, recharacterization, and reconversion is beneficial if the Roth IRA account has declined in value in the period after the Roth IRA conversion because paying tax on the lower account value will reduce the taxpayer’s total tax burden relative to the transaction.

Risks of Roth Conversion

In broad terms, a taxpayer needs to consider the investment risk and the risk of a change in circumstances. The investment risk relates to the potential for a substantial decline in value after the conversion and after the recharacterization period. A change in circumstances could relate to death, illness, disability, divorce or loss of a job, any of which can change the factors that made the Roth conversion election attractive.

Risk Minimization

For taxpayers converting a substantial account, there are sophisticated conversion, recharacterization, and reconversion options related to establishing multiple Roth IRA accounts and investing each account in a separate asset class. The objective toward the end of the recharacterization period is to recharacterize only the losers.

Tax Diversification

A large part of the conversion analysis hinges upon the taxpayer’s best guess as to future tax rates and the taxpayer’s own future income. One view of this is that taxpayers should consider simply diversifying the nature of the tax risk by having a mix of Roth and non-Roth accounts, similar to how individuals might choose to diversify the asset classes in which they invest.

Ideal Candidates

The benefit of a Roth IRA conversion is that the taxpayer pays tax today at a known tax rate instead of at a future, possibly higher, tax rate. That, of course, is the unknown. Generally, the conversion should benefit those who:

• Have sufficient outside assets to afford to pay the taxes resulting from a conversion with money from nonretirement funds;
• Expect to be able to wait many years before they need to begin making withdrawals from the Roth IRA account;
• Have made nondeductible contributions to a traditional IRA (in this case, the taxpayer’s basis in the traditional IRA may make the tax cost of conversion very manageable);
• Are looking to reduce the size of their taxable estate because the prepayment of income tax may bring their estate below the applicable limits (whatever they may be) for 2011 and future years;
• Have a Roth conversion that results in some or all future Social Security benefits being exempt from income tax;
• Expect their federal income tax rate to be higher at retirement due to higher income or change in income tax rates;
• Have current IRA or qualified plan accounts that are at a lower value due to stock market losses (the lower value would result in lower taxes upon conversion, and the recovery of the account would be tax-free); or
• Have large business losses, net operating losses, or large itemized deductions (in this case, the taxpayer should convert just enough to not create income or to create income taxable at lower marginal rates).

Conclusion

The recent tax changes have provided taxpayers additional opportunities to convert to a Roth IRA. Determining whether a Roth conversion is the right strategy takes thoughtful consideration. Taxpayers and their advisers will need to be mindful of many factors, including income tax rates, cash flow, length of time assets will remain in the Roth account, risk tolerance and financial planning objectives. With the right facts, a Roth conversion can provide significant tax savings and accumulation of wealth.

Tami M. Delaney and Bill O’Malley are with RSM McGladrey Inc.

This article originally appeared in the April 2010 issue of The Tax Adviser, the AICPA’s monthly journal of tax planning, trends and techniques. AICPA members can subscribe to The Tax Adviser for a discounted price. Call 800-513-3037 or e-mail taxsection@aicpa.org for a subscription to the magazine or to become a member of the Tax Section.