What’s the additional guidance on in-plan Roth rollovers all about?

Tedesco-KaraOn December 11, 2013, the IRS issued additional guidance (Notice 2013-74) on in-plan Roth rollovers (also known as “conversions”). As background, the Small Business Jobs Act of 2010 (SBJA) allowed 401(k), 403(b), and governmental 457(b) retirement plans that permit Roth deferrals to offer participants (or their surviving spouses) an in-plan Roth conversion of distributable vested pretax accounts (e.g., because age 59-1/2 has been attained) into an after-tax Roth option within the same plan.

The American Taxpayer Relief Act of 2012 (ATRA) added a twist to the existing law by removing the requirement that the in-plan Roth rollover amount had to be eligible for distribution. Effective January 1, 2013, as long as the plan allows Roth elective deferrals and in-plan Roth rollovers under the expanded guidance, participants can take advantage of an in-plan Roth rollover of both vested distributable and otherwise non-distributable pretax amounts.

The additional IRS guidance clarifies the questions surrounding ATRA and in-plan Roth rollovers of otherwise non-distributable amounts. In-plan Roth rollovers are permitted within 401(k), 403(b), and governmental 457(b) plans, irrespective of any otherwise applicable in-service distribution restrictions based on contribution type or other conditions (such as age). The amount must be vested prior to rollover, must retain the same distribution restrictions that applied before the rollover, and, being a rollover, no mandatory or voluntary withholding applies even though the conversion is taxable in the year it occurs. Participants may want to increase their withholding on sources outside of the plan to pay for the taxes on the conversion of the pretax account.

Plans need to be amended to allow for in-plan Roth rollovers. The guidance states the plan amendment needs to be adopted by the later of the last day of the first plan year in which the amendment is effective, or December 31, 2014. A calendar year 401(k) or 457(b) governmental plan that began allowing in-plan Roth rollovers in 2013 or 2014 has to be amended by December 31, 2014. A yet-to-be determined extended amendment deadline applies to 403(b) plans (but not before 2015 according to the IRS).

The additional guidance also provides that the plan can limit the types of contributions eligible for in-plan Roth rollovers and the frequency of the rollovers, and it can be amended to discontinue allowing them. If a participant has never made a Roth contribution to the plan, but requests an in-plan Roth rollover, the rollover is considered a Roth contribution and starts the participant’s five-taxable-year holding period for converted amounts and related earnings to be ultimately distributed from the plan tax-free (subject to certain other conditions).

The additional guidance should help plan sponsors decide whether to allow for the expanded in-plan Roth rollovers. Now that there is increased potential for a participant to convert his or her vested pretax account to after-tax dollars and pay the associated taxes now to save on taxes in retirement, plan sponsors may want to consider adding this feature to their retirement plan.

For more perspective on this new guidance, click here.