IRS Guidance on Conversions of Qualified Plan Accounts to Designated Roth Accounts

MARKET TREND: While much recent attention has focused on the deferral of income taxation, the current payment of income taxes in exchange for a future tax “break” may be preferable in certain circumstances. For example, this tax-planning strategy may affect the decision of whether to contribute amounts: (1) to a “traditional” 401(k) plan, under which the participant defers income tax on the contributions to the plan, and earnings thereon, until distribution, or (2) to a “Roth” account, under which plan contributions are taxed when made, but, if certain limitations are satisfied, neither those contributions nor the earnings thereon will be taxed when distributed.

SYNOPSIS: In the American Taxpayer Relief Act of 2012 (“ATRA“), Congress expanded the ability of participants in tax-qualified plans, tax-sheltered annuities, and governmental deferred compensation plans to convert amounts held in “traditional” accounts to amounts held under “Roth” accounts by removing the requirement that amounts must be distributable from the plan at the time of conversion. In recently released IRS Notice 2013-74, the IRS provided guidance on a variety of issues relating to these in-plan Roth conversions (referred to in the Notice as “in-plan Roth rollovers”), including the assets that may be included in an in-plan Roth rollover, the tax consequences of the in-plan Roth rollover, and restrictions on the distribution of amounts included in the in-plan Roth rollover.

TAKE AWAY: Depending on an individual’s overall financial circumstances, age, and thoughts about the future of tax rates, the use of a designated Roth account may be advantageous – particularly if the individual believes tax rates will be higher in future years and/or if the individual has a long-enough time horizon to retirement that a significant portion of the distributions from his or her retirement plan will represent earnings rather than a return of prior contributions. Since ATRA enlarged the base of qualified retirement plan assets that can be subjected to “Roth” tax treatment, employers have the ability to expand their tax and financial planning options with respect to retirement for their employees. Advisors to employers that currently sponsor qualified plans with Roth accounts or who wish to add the Roth account option can assist these clients in creating a compliant plan with an appropriately flexible in-plan Roth rollover feature.

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MAJOR REVERENCES:IRS Notice 2013-74.    Given the recent income tax rate increases under ATRA, much attention has focused on methods for deferring income taxation. In some situations, however, the payment of current income tax in exchange for the tax-free treatment of subsequent payments may be preferable. One such situation involves the use of a “designated Roth account” in a tax-qualified retirement plan, which allows the participant to pay taxes on current contributions and receive subsequent distributions from the account, income tax-free. Under ATRA, Congress expanded the ability of participants in tax-qualified plans, tax-sheltered annuities, and governmental deferred compensation plans to convert amounts held in “traditional” accounts to designated Roth accounts. Because of the increased flexibility afforded to plan participants through the availability of designated Roth accounts under a qualified plan, many employers have chosen to add these features to their 401(k) plan to enhance their menu of employee benefits.

HISTORY OF DESIGNATED ROTH ACCOUNTS

Most amounts held under tax qualified retirement plans are not subject to income tax when they are contributed to the plan. Instead, the amounts deferred – plus the earnings on those amounts – are typically subject to income tax when they are distributed. For many years, the principal exception to this rule was for amounts contributed on an after-tax basis — they were not subject to taxation on distribution, but the earnings on those amounts were taxable. Beginning in 2006, however, plans were permitted to maintain so-called “designated Roth accounts.” Amounts contributed to these Roth accounts are subject to income taxation at the time of contribution. If, however, a participant or beneficiary receives a “qualified distribution” from a designated Roth account, that distribution – including the portion attributable to earnings thereon – is not subject to income tax. For this purpose, a “qualified distribution” is one made after five years of participation in the designated Roth account and either: (1) on or after the participant’s attainment of age 59-½, (2) on or after the participant’s death, or (3) on account of the participant’s disability.

Under current law, participants in tax-qualified retirement plans with designated Roth accounts can convert amounts held under a “traditional” plan account to amounts held in a designated Roth account without regard to any annual income limitation (as applied before 2010). Unfortunately, before ATRA, amounts were only eligible for this conversion if they were currently distributable from the plan. Accordingly, in-plan Roth conversions generally were only available to participants who had separated from service with the plan sponsor or who had attained age 59-1/2 (i.e., the times when qualified distributions of 401(k) deferrals were permitted). Effective as of 2013, however, ATRA expanded the availability of in-plan Roth rollovers by eliminating the requirement that only “distributable” plan amounts could be converted, although it left some unanswered questions regarding rollover implementation. These questions were largely addressed in IRS Notice 2013-74.

IN-PLAN ROTH ROLLOVERS

Immediate Tax Consequences

Upon the rollover of amounts held under a traditional plan account to a designated Roth account pursuant to an in-plan Roth rollover, the portion of the rollover amount previously untaxed under the plan is treated as distributed to the participant for income tax purposes, and the participant is required to include that amount in his or her taxable income for the year of the transaction. Although incurring a current income tax liability may not seem desirable, an individual who believes that the tax rates applicable to his or her rollover will be lower than at the time of subsequent plan distributions might benefit from an in-plan Roth rollover. Similarly, if the participant’s time horizon until distribution is long enough that a predominant portion of his or her plan account will represent earnings as opposed to aggregate contributions, he or she may benefit from an in-plan Roth rollover, because it would exempt all the growth on the contributions from income taxation.

With regard to the taxation upon rollover, Notice 2013-74 makes it clear that, although the rollover amount is subject to current taxation, it is not subject to income tax withholding. Nevertheless, the participant still may be subject to estimated tax payments with respect to the amount includible in income, and employers may therefore wish to assist their affected plan participants by allowing them to increase the amounts they have withheld from their wages to accommodate this additional current tax deposit obligation.

Amounts Eligible for an In-Plan Roth Rollover

Notice 2013-74 clarifies that in-plan Roth rollovers are available for a very broad spectrum of plan contributions. They can be made in tax-qualified plans under Internal Revenue Code (“Code”) § 401(a), tax-sheltered annuities under Code § 403(b), and qualified governmental deferred compensation plans subject to Code § 457(b). Also, they can be made with respect to pre-tax employee deferrals, after-tax employee contributions, and employer matching or non-elective contributions. The only limitations appear to be that: (1) the amount subject to the in-plan Roth rollover is vested at the time, and (2) the relevant plan document allows the participant to make an in-plan Roth rollover with respect to the particular type of contribution. With respect to this latter requirement, Notice 2013-74 indicates that any restrictions on the types of contributions eligible for an in-plan Roth rollover and the frequency with which a participant may make an in-plan Roth rollover are subject to the relevant nondiscrimination requirements and applicable regulations governing the availability of a benefit, right, or feature.

Retention of Distribution Restrictions

Notice 2013-74 specifies that any plan-based restrictions on amounts before they were involved in an in-plan Roth rollover continue to apply after the rollover. For example, if a participant effects an in-plan Roth rollover of pre-tax elective deferrals that had been subject to a prohibition against distribution before the participant attained age 59-½, had a separation from service, or met any other of the restrictions on distributions applicable to elective deferrals under Code § 401(k), these restrictions still apply to the amounts following the in-plan Roth rollover.

Calculation of Five-Year Period for Qualified Roth Distributions

Notice 2013-74 makes it clear that if the in-plan Roth rollover is the first amount contributed to a designated Roth account under the plan, the five-year period for determining whether a distribution is qualified begins on the first day of the taxable year in which the in-plan Roth rollover was made. On the other hand, if the participant had been making contributions to a designated Roth account under the plan in which he or she effected an in-plan Roth rollover, the five-year period applicable to the in-plan Roth rollover is the same as that applicable to the earlier contributions under the plan.

Required Plan Amendments

If a plan does not currently provide for an in-plan Roth rollover of amounts not otherwise distributable from the plan, generally, a plan amendment to a 401(k) plan or a governmental 457(b) plan must be made by the last day of the plan year in which the amendment is effective or, if later, December 31, 2014. In addition, provided this deadline is met, the fact that a safe harbor 401(k) plan began allowing in-plan Roth rollovers mid-year will not cause the plan to fail the safe harbor requirements. For 403(b) plans with respect to which the employer has timely adopted a plan document, the amendment is required before the end of the applicable remedial amendment period.

TAKE AWAYS

* Depending on an individual’s overall financial circumstances, age, and thoughts about the future of tax rates, the use of a designated Roth account may be advantageous – particularly if the individual believes tax rates will be higher in future years and/or if the individual has a long-enough time horizon to retirement that a significant portion of the distributions from his or her retirement plan will represent earnings rather than a return of prior contributions.

* Since ATRA enlarged the base of qualified retirement plan assets that can be subjected to “Roth” tax treatment, employers have the ability to expand their tax and financial planning options with respect to retirement for their employees.

* Advisors to employers that currently sponsor qualified plans with Roth accounts or who wish to add the Roth account option can assist these clients in creating a compliant plan with an appropriately flexible in-plan Roth rollover feature.

Jeffrey S. Adler, CLU