Fiscal Cliff Legislation Expands In-Plan Roth Conversions for Qualified Plans

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On January 2, 2013, President Obama signed into law the American Taxpayer Relief Act of 2012 (the “Act”), more commonly known as the fiscal cliff legislation. Among other things, the Act amended the tax code to remove some of the prior restrictions on in-plan Roth conversions in qualified retirement plans.

An “in-plan Roth conversion” permits a participant in a Section 401(k) plan, Section 403(b) plan or Section 457(b) governmental plan to convert pre-tax amounts already inside the plan to after-tax Roth amounts inside the plan. The conversion requires the participant to pay income taxes on the amounts converted in the year of the conversion, but those amounts and earnings on those amounts can then be withdrawn from the plan tax free at a later date.

In-plan Roth conversions were first permitted in 2010 by the Small Business Jobs Act. Under the Small Business Jobs Act, the conversion was only available if: (1) the plan permitted a participant to make Roth contributions from the participant’s pay; and (2) the participant was otherwise eligible for a distribution from the plan. As a result, the number of participants who could take advantage of an in-plan Roth conversion was limited. (For more information on the 2010 legislation, please see our previous alert “In-Plan Roth Conversions May Require Plan Sponsors to Take Immediate Action”.)

The Act expands the availability of in-plan Roth conversions by removing the requirement that a participant must otherwise be eligible for a distribution to convert pre-tax amounts to after-tax Roth amounts inside a plan. As a result, any participant, regardless of age or eligibility for a distribution, may elect an in-plan Roth conversion if permitted by the plan.

A plan is not required to offer in-plan Roth conversions. If a plan wants to offer (or expand) its in-plan Roth conversion rights, the plan will likely need to be amended prior to permitting the conversions. The expanded rule applies to all conversions made after December 31, 2012.

Until the IRS issues further guidance, many questions remain, including whether a plan that currently offers in-plan Roth conversions must be expanded to offer the in-plan Roth conversions to all participants.