The Small Business Jobs Act of 2010, passed earlier this year on September 27th, opened up the possibility of completing an in-plan Roth conversion rollover from a 401(k) or 403(b) to a Roth 401(k) or Roth 403(b). However, the rules are not quite as simple and flexible as typical Roth conversions, due to the fact that the account is still first and foremost a qualified employer retirement plan. Fortunately, the IRS has issued guidance to help individuals understand the details of the new rules - which is fortunate, because there are some significant differences that could otherwise catch clients (and their planners) unaware!
The new guidance - IRS Notice 2010-84 - and its supporting information clarify several ambiguities of the new in-plan Roth rollovers, which technically became available as soon as the Small Business Jobs Act legislation was passed into law (i.e., for any distributions made after September 27, 2010).
The new guidance clarifies (Q&A-19 & 20) that in order to make an in-plan Roth rollover conversion, first and foremost the qualified plan must actually have a designated Roth account option in the plan. In other words, if the 401(k) plan doesn't have a Roth 401(k) option in the first place, you can't complete an intra-plan Roth conversion. Currently (for 2010), this is only possible for 401(k) and 403(b) plans; beginning in 2011, it will also be possible for governmental 457(b) plans.
The conversion rollover itself may be accomplished as a direct rollover (i.e., the plan administrator moves the money directly from one account to another), or as a distribution that is rolled back into the Roth side of the plan within 60 days. (Q&A-1)
Notably, plan participants can only convert amounts that are otherwise eligible to be distributed from the plan in the first place. Consequently, unless the plan allows for in-service non-hardship withdrawals, employees will only be able to complete in-plan Roth conversions if they are over age 59 1/2, disabled, or have separated from service. (Q&A-2) (Special provisions also apply for qualified reservists.) Plans may be amended to expand their eligible distribution rules for the purposes of in-plan Roth rollovers. (Q&A-4) Surviving spouse beneficiaries may also complete in-plan Roth conversions of the decedent's account balance, as a distribution due to death (of the original participant) is also an eligible distribution. An alternate payee who is a spouse or former spouse of the plan participant may also complete in-plan Roth rollovers. (Q&A-14)
When the conversion occurs, the fair market value of the investments rolled over are reported for tax purposes, reduced by any basis the participant has. Because the full fair market value is reported in income, the special election for Net Unrealized Appreciation of employer securities will not apply to a Roth conversion transaction. If there is an outstanding loan associated with the account, the conversion may still occur, but the outstanding balance of the loan is also included in income. The 20% mandatory withholding rules will not apply to direct in-plan Roth rollovers. If the Roth rollover distribution occurs in 2010, the 2-year averaging provision to spread the income evenly into 2011 and 2012 may still apply (and if a subsequent withdrawal occurs before the end of 2011, income acceleration rules still apply as well). If the Roth conversion is withdrawn within 5 years, the application of the 10% early withdrawal penalty may still apply to the Roth conversion principal. (Q&A-7 through -13)
In an exception to the otherwise typical rules for Roth conversions, it is important to note that in-plan Roth rollover conversions may not be undone via a recharacterization; once the Roth conversion occurs, it is irrevocable. (Q&A-6)
Eligible qualified plans technically must be amended to allow for in-plan Roth rollover distributions. However, in a special grace period from the IRS, plans may allow for such conversions now, and finish amending their plans later, as long as the amendments are done by the later of the last day of the plan year to which the amendment applies, or December 31, 2011 (whichever is later).
From the planning perspective, it's important to point out that technically, the only individuals who can complete the new in-plan Roth rollovers are those who could have already completed a conversion to a Roth IRA at any point in the past or future (since only those who can otherwise make a distribution from a plan are eligible). Consequently, the reality is that the opportunity for in-plan Roth rollover distributions is not really an opportunity for a new conversion that couldn't have been done in the past; it's simply an opportunity to do the conversion, and be able to keep the investments inside the employer retirement plan.
On the other hand, it is important to bear in mind the restrictions that do apply - most significantly, that the plan has to offer a designated Roth account in the first place, and that only those who can take an eligible rollover distribution (due to separation from service, death, disability, or attaining age 59 1/2) can complete in-plan Roth rollovers, unless the plan allows for in-service non-hardship distributions. Consequently, many individuals will not be eligible, until/unless the plan is amended to allow for in-service non-hardship distributions (although the guidance makes it clear that such amendments certainly can be done, and can even be done only for the purposes of in-plan rollovers).
In the end, though, the factors that dictate whether a Roth conversion will be desirable or not, in the first place, are still controlling. The new in-plan Roth rollover option is simply another potential way to get a Roth conversion done (if the distribution is allowable at all), assuming a conversion makes sense for that client in the first place. Now planners will simply have to decide, in addition to whether the conversion is appropriate at all, whether the conversion assets should be rolled into the plan's designated Roth account, or an outside Roth IRA. And be certain that your client really wants to do an in-plan conversion if you do go down that road, because it cannot be undone via a Roth recharacterization!
So what do you think? Have the new in-plan Roth rollover options stirred new client interest in Roth conversions? Or is this not really such a big deal for your clients?