The recent “fiscal cliff” tax law, the American Taxpayer Relief Act (ATRA), includes a provision effective Jan. 1, 2013 that greatly expands the ability of plan participants to convert pre-tax plan accounts to after-tax Roth accounts, making all plan accounts potentially convertible. This is an optional provision that can be added to any 401(k), 403(b), or governmental 457(b) plan that allows Roth contributions. Before plan sponsors open up this opportunity, however, there are a number of practical issues to deal with.
Since 2010, plans have been able to offer “in-plan” Roth conversions, but only for amounts that were otherwise distributable under the plan. Generally this meant a participant had to be at least age 59-1/2 or have terminated employment in order to elect a conversion of some or all of the distributable amount. All pre-tax funds converted, including a participant’s elective deferrals and any distributable employer contributions, are immediately taxable. But the amount rolled back to the Roth account (often net of money needed to pay taxes) is not taxed again when a distribution is taken in the future. Also, future earnings on the Roth rollover are not taxed either, provided it remained in the Roth account at least five years and the participant was at least age 59-1/2, was permanently and totally disabled, or died.
ATRA ExpansionThe new law provides the opportunity to allow an in-plan Roth conversion of “any amount not otherwise distributable,” after 2012. This could include elective deferrals of younger active participants, as well as any employer contributions. The law provides that the plan will not violate the usual restrictions on the timing of distributions by allowing the conversion. The amounts converted are still immediately taxable, which is why this provision was added to ATRA at the last moment—it is projected to raise $12 billion in new revenue in the short term.
About half of 401(k) plans have added Roth accounts, and only some of those allowed conversions under the prior law because it was so limited. It is likely that participants (and their financial planners) will soon start asking about the opportunity to make expanded Roth conversions. And indeed, converting to a Roth when the participant is in a lower tax bracket can make sense. But since this is a permanent addition to the Code, not a limited window of opportunity, plan sponsors can take the time to consider some practical issues first or wait for further guidance.
- This new conversion right is structured as an add-on to the prior law, not a replacement of it. Therefore plan sponsors have the option to offer no conversions at all, conversions of distributable accounts under prior law, or conversions of both distributable and non-distributable accounts starting in 2013. Until further guidance is provided, plans should probably track the distributable and nondistributable conversion amounts separately.
- Income tax is due on the full amount converted. The participant still will not have access to funds that are not distributable, and no income tax withholding will be taken on nondistributable amounts. So participants will have to use funds outside the plan (or take a loan from the plan) to pay the taxes on an expanded Roth conversion.
- The law is not clear as to whether non-vested employer contributions can be converted. It would make little sense to pay tax on conversion of amounts that might later be forfeited. Presumably the plan design could restrict the conversion to vested account balances to simplify administration.
- The law is also not clear on what distribution rules apply to the new Roth amounts after the conversion. On the one hand the money has been taxed and “shall be treated” like a rollover. The existing Roth regulations (issued before either type of conversion was available) say that Roth accounts can track rollovers separately so that they are not subject to distribution restrictions that apply to 401(k) elective deferrals, whether pre-tax or Roth. But fully treating these conversions like rollovers could allow an end-run around the 401(k) distribution rules. For example, could a 40-year-old convert nondistributable pre-tax elective deferrals, keep them in a “rollover” Roth account for five years, and then start taking distributions, long before he would have reached age 59-1/2 and been able to take the original elective deferrals absent the Roth conversion? It seems unlikely that Congress could have intended such a result as a matter of retirement policy, even for a short term revenue gain.
Because this law just took effect and there is plenty of time for participants to take advantage of it in 2013, we recommend that employers wait for further guidance. Alternatively, employers could structure the Roth conversion in their plans to keep “otherwise nondistributable” amounts subject to withdrawal restrictions even after conversion, until guidance comes out.